Consumer Spending, How Did We Get to Where We Are?

          A recent trend indicates a deceleration in the consumption of tangible products. Why?

Between 2020 and 2021, we made substantial investments in our residential property by procuring high-value items for our living spaces, garages, and storage areas.  Now we all need to have one huge garage sale and purge.  It is because of this the worth of “collectibles”, excluding gold, is currently on a decline.  This has lead us to believe that  the consumption of experiences can be observed to be at its peak or after it has passed its peak, depending on the individual’s underlying ability to consume. Because of inflation, consumers are having to redirect their funds to bills rather than buying unneeded “stuff”.   

Food price inflation is a prevalent economic phenomenon that affects a vast number of consumers. The severity of this issue is evident in the fact that individuals who may not typically align with the same political party are now supporting Walmart’s value proposition.  Adding insult to injury, the decrease in SNAP benefits and reduced tax refunds have affected the expenditure patterns of consumer segments belonging to the lower-middle income bracket.

        As it relates to earning season

The impact of weather on sales during the spring season is significant. However, it is noteworthy that the lost margin dollars are rarely recovered.  During the month of March, there were unfavorable outcomes. April did not perform exceptionally well, and May had a combination of both positive and negative results.

What is the forecast for the month of June?

The user experienced a sudden realization that they must resume making payments on their student loans starting in June.  Consumer expenditure is typically influenced by the economic reality, which is expected to experience a significant disruption in June for approximately 40 million borrowers.

Bank Earnings to Housing Starts 

As the week came to a close, economic data on earnings dominated the headlines, with bank earnings a major focus, and other data indicating a weakening economy, with manufacturing struggling and housing remaining problematic. The market is not particularly fond of what it is saying.  We also needed to add that Janet Yellen stated the US & China relations could incur an economic cost, and Republicans unveiled a plan to raise the debt ceiling while slashing portions of the President’s agenda.

This week there was a significant decline in activity. In general, the markets and economic data have experienced a variety of outcomes. If you want to look at it from a positive perspective you might say, there were no unpleasant revelations along the bank earnings.  I was shocked.  The trend of larger-than-anticipated withdrawals of bank deposits seems to loom.  Looks like the big losers were Schwab and Western alliance, each with an 11% decline.  We are keeping an eye on more distressed selling, which could put downward pressure on values and upward pressure on volatility.

The anticipated capital constraints are not nearly as alarming as originally anticipated they would be in mid-March. Therefore, there is positive news on this front. There were some ominous headlines about falling valuations, individuals returning their keys, and large loans entering special servicing. CalPERS had written down the value of his office portfolio by 20%. Because of this a large California pension fund marked down the value of its assets by $52B.  This could be just the start.

We are of the opinion that those who own office buildings in markets like: San Francisco, Washington, DC, Baltimore will be hit the hardest.  For example, Blackstone announced that their distributable earnings had decreased by 36% to approximately $1.2B and their stock had lost 2% of its value. Oddly enough I hear they are putting another fund together. 

In other news, the housing market data was subpar, and builder sentiment remains negative. As we review housing starts, they decreased in March, despite the fact that single-family housing construction increased by 2.7%, while multifamily housing construction decreased by 5.9%.  Because of that housing stock prices fell roughly eight-tenths of a percent. Permits for construction decreased by 8.8% to a rate of 1.41M.  Used homes transactions decreased by 2.4% in March, representing a 22% decline from the previous year.

We are seeing the constraints playout as it pertains to the effects of higher interest rates on single-family homes, as builders reduce prices to attract purchasers. According to the National Association of Homebuilders, approximately 30% of builders lowered their prices in April in an effort to increase business activity and sales in their respective markets.

Inflation to Unrealized Losses

Consumer inflation came in lower than anticipated, with some pockets of stickiness, but wholesale inflation showed the greatest drop in three years. Investors analyzed the data as it was given, giving both sides of the rate rise argument something to hold onto. Following last week’s employment report, which revealed that pay growth was moderating, it seems that inflation seems to be heading in the correct direction.

We received two low-inflation numbers, the CPI saw marginal movement.  It came in at or slightly below estimates, however the PPI was much lower than anticipated. We all know where this is going to end up for all of us is going to be higher than we like.  Keeping in mind that last week’s employment data was better than anticipated, the ride is not over yet.  However, one interesting point, food costs fell in March compared to the previous month.  This has been the first time since September of 2020, we saw a decrease in this category. 

Based off the conversations we have been having most were hinting to the Fed hinting to a 25 – 50 basis point rate hike.  However, based off the previous data, it seems like some of the Fed members might be rethinking that approach.

Some context cluse hint that some investors and market observers believe the peak of inflation has passed.  When you look at the two-year Treasury yield at a 10-year rate it was unquestionably lower where they were present than it was elsewhere.  We are not out of the woods yet and we may not have seen the last of it from the banks.  In fact, Warren Buffett stated last week that future market volatility would increase.  As we move past the SVB crisis, and to the best of our knowledge no other banks have fallen.  We are still tracking bank deposits and the amount of withdrawals is a bit over $300B.  The amount of liquidity floating around out there has been strained stemming from banks hoarding assets.  A lot of eyes will be on the banks as earning will soon be released, and this will help to paint a picture of the short-term future looking into the compression of their margins and/or a rise in the cost of deposits.

Since the rates on the 10 year and five-year treasuries decreased by about 40 basis points that could lead to securities holdings increased by nearly $100B in Q1.  Also, the yield on the one-year Treasury decreased by around nine basis points.  This is helpful to increase the value of those securities held until maturity to the tune of 50B+ adding approx. 2% over Q4, and the value of the securities for sale increased by around 45+B.   That being said, this should help lessen the unrealized losses.

From Employment to Sales & Margins

Last week the main focus was on the banking sector, this week it has primarily shifted the economy as it relates to employment. Various indicators resulted in about a 40% decline in the private sector.  Reflecting back to March, job openings fell below 10MM, while new unemployment claims were also higher than anticipated.  Keeping in mind this information does not reflect the unwinding after the fallout from SVB. 

The Fed has continued to echo that their true bellwether as it relates to slowing inflation will be the employment market.  When you realize the most recent rate hikes, it appears that we may be experiencing the deterioration in the labor market we have been anticipating. The initial indication of the labor market beginning to weaken, so private sector hiring slowed last month.

According to Automatic Data Processing “ADP”, private sector employment increased by 145K in March, which was 40% less than the headline number in February. This was below the estimate of 210K and a significant decrease from Q1 22.  Adding insult to injury we are also seeing a deceleration in job growth, and are tracking a slowdown in pay growth as well.

After a year of robust hiring and wage growth, employers are throttling back.  Fascinatingly, employment growth was almost evenly divided between the services and goods sectors, keep in mind historically the services category leads.

The McDonald’s shutdown was announced as they closed their corporate offices and prepared for layoffs.  There was a time not too long ago, when McDonald’s was reporting various consumers were patronizing their restaurants who typically would eat elsewhere, and their sales were reflecting as such.  Now we are seeing they too are experiencing a drop in sales.  McDonald’s noted that inflation is also cutting into their 2023 forecasted margins. 

We are seeing the competitive recruiting environment over the past 18 months is beginning to pull back.  I have said time and again, the last in will be first out.  Those who changed jobs for a few extra bucks will likely be calling their previous employer back before too long.  What is one to do, when year-over-year gains for those who stayed in their jobs fell by about 7%.  Compared to that, the pay growth for those who switched jobs was also down by 14%.

As we take a look at the effect the slowing labor market and how it is playing out with various retailers we like to focus on Costco.  The reason being is that consumers patronize their local stores for a wide array of products.  In March Costo saw same store sales decline, this was the first decline since April of 2020.  Their sales were net -1% when you back out the robust February they experienced.  When you look at Costo’s breakdown of their sales, we are under the impression that the bulk of the pullback happened to fall into the discretionary items (home furnishings, toys, seasonal products…)

Turbulent Outlook

Investing in commercial real estate is significantly more complicated than purchasing and selling residential properties. You can invest in individual assets, investment funds, real estate investment trusts, and numerous other vehicles. Because there are numerous methods to invest in commercial real estate, and the recent complexity of volatile capital markets can further complicate matters.

When we discuss with a perspective partner, we like to break it down to what is the best match for their goals and objectives. We take a discretionary approach while making investment decisions, to what is the best fit for what they’re trying to do.  

After a great run for about eight years, we are hearing numerous different adjectives to describe the market conditions, “turbulent” seems to be the most accurate.  Many want to run from volatility, on the contrary we embrace it, as it tends to expose your true DNA.  Our experience shows you will be embraced when you have a differentiated strategy and a differentiated company, and if your approach is dissimilar than every other firm.  We are successful with our capital-raising meetings because of our niche strategy. 

Again, despite the fact that the world is unstable, we relish in it because it has allowed us to stand out from the crowd.  We are somewhat enthusiastic about the prospect of being able to take advantage of these opportunities.  As we look ahead, there is going to be a 12- to 18-month capital markets opportunity to purchase assets with debt maturities.  Sellers who are under pressure to sell, or companies seeking to raise capital that need to dispose of commercial real estate.    

We are seeing most distress in those organizations that have used variable rate debt, and we expect this to be the narrative of the next six months or so.   Because of these decisions, it will create opportunities for organizations like ours with fresh powder and large, integrated owner-operator teams to take advantage of the current congestion. 

If you have an asset you want to get off of your books, or have funds to place, either way we would like to talk with you to provide a possible solution.   

What Is SVB

The Fed increased interest rates by 25 basis points this week in response to worries about bank solvency. While the Fed Chair’s remarks showed a dedication to fighting inflation, the rhetoric was slightly different. Meanwhile, Treasury Secretary Janet Yellen and congressional statements appeared to kill the notion of a blanket deposit or insurance scheme, and investors took note. Meanwhile, the financial fallout continues, with Silicon Valley branding and Credit Suisse lunacy.

I believe that these disruptions, whether they are supply chain, increased interest rates, unemployment, retail downturns, and so on, will not last indefinitely. We come out of these, even when we were at our darkest in 2008 and 2009, when there were cutbacks across the board and the financial system in the United States was creaky across many sectors. If not collapsing, subsidies were abundant, and CMBS and CRE delinquencies skyrocketed. Even at the time, I felt like things were being rebooted. That, I believe, is where we are now. Things are being restored. But I believe the market has yet to fully comprehend how agonizing this will be for everyone, not just care and CMBS. However, for the larger industry. I believe that until March 10 or March 9, when Silicon Valley had that $42 billion withdrawal day, the care market and the US economy were already facing extremely strong headwinds, rising interest rates were really starting to bite, and problematic sources of capital were drying up. And that was before we saw the bank rush.

Why am I so pessimistic? There are a few causes for this. The first reason is that I believe this depositor withdrawal problem has only revealed the top of the iceberg at this time. If you’re a CFO with more than $250,000 in liquid assets, you’re spending your days, nights, and weekends attempting to distribute it to different institutions. You’re pulling it away from neighborhood banks, and in some instances, regional banks. And what that does is increase the probability of more problems and bank runs down the road; without a question, it raises the likelihood that we will see more bank failures; the glass half full is that we are restricted to only a tightening of credit, right? The advantage of this is that in the worst-case scenario or best-case scenario, banks simply cease financing but do not go out of business. So that’s a very, very frightening spot to be.

The second reason is that with the CES buyout, the 81 creditors incurred losses rather than the stock holders.  These were notes released to assist banks in improving their tier one capital. And it was assumed that the United States would always be top in terms of shareholder ownership. As a result of the 81 investors bearing these losses, credit risk premium spreads on 81 bonds multiplied overnight, from handles of seven or 8% yields to handles of 15%. That dragged the entire risk yield curve higher, broader, and more agonizing. So, if it was difficult for CMBS borrowers to price risk to responses to issue CMBS loans or right CMBS loans two weeks ago, it is now nearly impossible!

 When you combine these two factors, banks are being restricted in their ability to give, while CMBS are unable to make loans at this time.  This indicates that the capacity to obtain or the availability of money has just hit a brick wall. That means no construction loans, difficult refinancing, the concern for possibly less lending. We have no idea where this will lead us, and it concerns me greatly!