By Ryan Severino, CFA – Chief Economist, JLL
June 21, 2019
Sometimes it feels like watching a tennis match, or maybe ping pong. But keeping track of the geopolitical climate these days proves quite a challenge, even for savvy veterans of political risk analysis. No shortage of risks exists and their idiosyncratic and capricious nature makes understanding their implications for the economy and commercial real estate (CRE) a complex process. To simplify this, let’s break things down a bit. Let’s first look at the major political disruptions. Then let’s look at the current state of things versus the potential state and make connections between what’s unfolding and CRE.
We are currently grappling with the greatest geopolitical risk in decades, likely since the end of the Cold War. Listing all the risks could take an entire column. Most prominent for CRE sits the relationship between the U.S. and China. Most directly, this manifests itself as trade tensions. But the growing tension across the relationship adds risk and further complicates the trade picture. Trade tensions with other trading partners, including Mexico, the European Union, Japan, and India also create potential headwinds.
Yet we shouldn’t discount the importance of other political risks. Populism and nationalism remain ascendant in many countries around the world, including many democracies. These forces can often give people what they want, even if those measures are economically counterproductive. Brexit remains a key risk, with resolution of that situation (for better or worse) unlikely until at least October. Domestic political tension in the U.S. remains heightened, especially now with Democrats controlling the House of Representatives. And tensions in the Middle East, always at least simmering, have ratcheted up in recent weeks. Got all that? Good. Because those are just a handful of things unsettling the economy.
How have these developments been impacting things thus far? Thankfully, the impact from political disruption seems muted so far. Drag on the overall economy looks limited, no more than 10-20 basis points of economic growth in 2019. But signs of impact exist – prices for goods under tariffs have gone up and the sour mood is slowly impacting consumer and business sentiment. In the CRE markets, we see little sign of direct disruption. Industrial faces the most direct risk, but thus far demand remains strong enough to more than offset any fallout from trade. On the capital markets side, the story looks similar. Any caution from investors because of geopolitical risk does not show up in the data. Across markets, cap rates hover at or near record-low levels and unlevered total returns, though down from a few years ago, still offer compelling relative value versus other asset categories.
But when we train our sights on the future, we see the potential for greater fallout. Knowing exactly how these political risks will unfold seems impossible. So far, some evidence that the risks are negatively impacting the economy is emerging. But their precise outcome is unclear. And that uncertainty sits at the heart of the problem. If the risks do not materialize and end up relatively benign, the economy can continue to grow around 2 percent over the next 12-18 months which would provide a solid backdrop for CRE. If the risks break the wrong way, then the drag on economic growth could become profound and CRE could experience slowing rent growth (if not outright declines) and vacancy rate increases. My base case does not see this occurring, but the mere possibility of this is causing businesses, investors, and increasingly consumers to pause a bit. And as more of them do, a slowdown becomes a bit of a self-fulfilling prophecy.
On the capital markets side, the situation seems even more complex because in addition to the political realm we also contend with the Fed and its monetary policy decisions and their attempts to respond to these risks before they imperil the economy. Again, if the major risks do not materialize, cap rates and values can continue to plod along until the economy ultimately slows, which we think will occur inevitably as fiscal stimulus fades. But if the Fed senses that these risks pose a threat and they cut rates then they risk engendering an asset bubble, including CRE. That risk of an asset bubble becomes most prominent if the Fed cuts rates and the risks to the economy either don’t materialize or don’t impact the economy as negatively as the Fed expected. Either way, things should get very interesting in the CRE world!