Anticipating the end of the current cycle? What you think matters probably doesn’t.
One of the most—if not the most—commonly asked questions in real estate and business is when will this cycle come to an end? The question is usually followed by a nauseatingly common analogy involving baseball innings. Still, the question is a legitimate one. Though the end of a cycle cannot be precisely pinpointed, it is possible to understand the nature of cycles and various factors that influence them. Real estate professionals and the business community as a whole would be well advised to take these insights into account.
The first thing to understand about real estate cycles is that they are driven by the business cycle (or the growth and contraction of the broader economy). In this sense, they are virtually one and the same. Everything from world equity values to real estate pricing and rents (across all property types) are driven by the business cycle.
Using employment growth as the primary measure of a cycle’s lifespan, the last three recoveries and expansions have lasted just under eight years. Although the aftermath of the Great Recession left many without the “feel good” factor of previous recoveries and expansions, the economy has been growing for quite sometime and the current cycle is aging.
The cycle which began in mid-2009 is currently approaching the eight-year mark. Does this mean the end of the current expansion is near? Not necessarily. Time alone is not a reliable predictor of when economic downturns occur. This begs the question, what will cause the next recession and when will it be?
News headlines often elicit pessimistic outlooks courtesy of whatever the dramatic news story of the day may be. Everything from natural disasters, wars, and lately elections, are examined for their potential to derail the U.S. and global economies. Although these events are important in many respects and indeed can be unnerving, exogenous factors have not affected the last several economic cycles. In fact, if one were to examine U.S. economic cycles over the past several decades, it becomes clear that the events which garner the most media coverage (such as wars, trade deals, natural disasters, terrorist attacks and elections) do not have much impact on the duration of a cycle. This is not to say that geopolitical events aren’t important and are without economic consequence. They are often important, but their effects tend to be more nuanced and impact economic dynamics over a longer period of time. (see corresponding geopolitics graphic)
So, if many of the big events of our time do not influence the lifespan of a cycle, what does? In the case of the U.S. it’s usually something internal that derails the momentum of the nation’s economy. For example, the past two recessions were brought on by imbalances that built up. In the case of the early 2000s, the bursting of the tech bubble impacted growth. Later in the same decade, an overheated housing market brought on by lax lending standards nearly led to an economic depression.
As imbalances build and growth becomes unsustainable it impacts interest rates. When looking at the federal funds rate history going back to the 1980s, there has been a clear downward trend in interest rates. However, if one looks at where interest rates are relative to where they have been within a shorter time span, interesting patterns emerge. When interest rates spike relative to where they had been in the few preceding years, recessions follow in short order. With this in mind, what does all of it mean in the year 2017?
Interest rates (federal funds) have been at historically low levels for years. In the years immediately following the Great Recession, the official policy rate was between zero and 25 basis points (bps). Starting with the first post-recession rate hike in December of 2015, a gradual pace of rate increases has occurred, but the official policy rate remains between 75 and 100 bps—not enough to constitute a spike. Still, the neutral rate of interest rates (a rate at which interest rates are neither simulative nor contractionary) is likely to be lower than it has been in the past. Given the current outlook and the most probable course of interest rates with respect to those expectations, the current cycle likely has some room to run in 2017 and into 2018.
With this in mind, what should real estate professionals be thinking about? These factors will influence real estate market fundamentals as they reflect economic realities. CBRE’s analysis has shown that the cycle does not just impact markets broadly, but it also carries impacts on the industry level. Whether looking at tech, energy or financial services, the demand profile within markets will be affected by economic ebbs and flows. With an understanding that we are in the later stages of the current cycle, prudent steps can be taken by occupiers and landlords alike with the aim of minimizing the disruption of economic downturns to their businesses.
There are a couple of key points worth keeping in mind that will have important indications for the lifespan of the current economic expansion. First, keep an eye on interest rates. As rates climb, and particularly if the pace of change notably increases, it should be factored into cyclical thinking. Second, exchange rates should be monitored. As economic performance and corresponding interest rates diverge around the world, it will have important implications with regard to foreign exchange rates. Notably, emerging markets hold trillions of dollars in dollar-denominated debt. The Bank for International Settlements puts this amount at more than $3 trillion. If the value of the dollar continues to increase, these debts become more expensive to pay back. This could carry serious implications for the global financial system and aggravate a cyclical downturn. As such, this is something that should be watched.
To conclude, although the current cycle is aging and is in its latter stages, there is still some room to run. Though political developments and other news headlines are important, their impacts on the economy are longer term and more nuanced than many realize. Instead, real estate professionals should keep an eye on interest rates and foreign exchange rates for clues on when the next downturn will occur and how severe it might be.
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