Market Commentary

Something has to give.
December 22, 2009

Something has to give.  Either the yield curve—the most fundamental and forward looking indicator--is correct and the headlines surrounding commercial real estate are wrong or vice versa.

The difference between the two year and ten year treasury notes widened to a record on anticipation that an accelerating recovery will fuel inflation.  It is currently around 281 basis points versus 145 basis points this time last year. 

Some will write this record steep slope is a function of massive treasury supply coming to market to fund the most ambitious government since the New Deal.  While I do agree this is a contributory factor it is not the primary reason.  Last week the FRB stated its intent to keep short term interest rates low for an “extended period of time” to ensure the recovery has indeed taken hold.

In my view the Federal Reserve Board was slow to respond to the financial crisis and I think the odds favor the Central Bank will blow it on the upside.  Yes the Federal Reserve is ending some of its alphabet soup of liquidity enhancing vehicles by February 1; I believe it will be slow to raise the overnight rate back to the long term neutral rate of 3.0% to 3.5%.

Pundits of this recovery view however write commercial real estate is the proverbial “other shoe to fall”.  Last count this will be 349^th other shoe to fall in this ebbing crisis.  Yesterday Moody’s wrote commercial real estate prices fell 1.5% in October from September, down 36% from a year ago and 44% below the peak set in October 2007 and are now around August 2002 levels.

The real estate consulting firm of Foresight Analytics stated Monday there is $1.4 trillion of commercial real estate debt scheduled to mature in the next five years and about 53% of it is underwater.  The firm further stated prices may decline 50% from its peak; delinquencies will rise from today’s 4.47% rate to perhaps 5.6% in the fourth quarter and 8% next year.

I will admit this data is discouraging but in my view, these estimates are already widely projected, assuming no change in today’s environment. 

Data provided by the US Bureau of Economic Analysis suggests a strong correlation between national GDP and commercial real estate values.  Values tend to peak about 1 or 2 quarters after the peak in GDP and bottom about 1 or 2 quarters after the recession ends.  Vacancies follow the same trend but in the inverse.

This common sense and historical pattern appears to be lost in the discussion surrounding commercial real estate.  I will also write it is my first hand experience an issue does not become an issue if discussed beforehand as solutions will inevitably to be found before a crisis develops.

If the economy is expanding at the pace the yield curve is suggesting and if historical patterns remain true, and if today’s discussions discover solutions, fears of a gargantuan bust in the commercial real estate sector will go the same way as last winter’s fears about bank nationalization. 

At casual glance, the three poster child banks of the credit crisis raised about $53.4 billion in equity during the last two weeks.  If I wrote eight months ago two of the largest equity offerings in history would occur by year end—equity offerings in the financial sector no less—I would be regarded at best Pollyannaish.

Turning briefly to yesterday’s market action stock advanced and bonds declined on the economic acceleration theme.

Today existing home sales, home price index, Richmond Fed and final revision to third quarter GDP is released.

Last night the foreign markets were up. London was up 1.02%, Paris up 0.67%, and Frankfurt up 0.36%.  Japan was up 1.91% and Hang Sang up 0.69%.

The Dow should open moderately higher on the belief the recovery is gaining momentum.  The 10-year is off 15/32 to yield 3.73%.