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This Challenging World

May 18, 2020

• Unprecedented rise in government deficits and indebtedness globally
• New Zealand announces a budget worth a staggering 17% of GDP
• Global debt to GDP set to rise to 108%
• Governments and central banks will have to be creative to keep the potential damage to bond markets in check
• How far off is a Minsky moment?
• Work-from-home as a structural shift a challenge to the REITs.

As the COVID-19 situation moves on legacy problems are becoming more evident. Top of the list is a massive increase in government spending that still has no bounds. Also, in this note we look at the real estate sector where working-from-home is probably not transitory but a major challenge to the expected growth of the office sector.

Who is going to pay? New Zealand is just one more example of the huge scaling up of government spending and with it government deficits and debt. JPMorgan estimates that the global government fiscal deficits will collectively jump a record 7.2 percentage points this year to 11.9% of GDP a record.

New Zealand last week announced a government spending program that economists estimate will take government net debt to GDP up from 19% of GDP in 2019 to 53.6% in 2023. Initial spending amounts to a huge 17% of GDP. The government is hoping that their actions will enable unemployment to fall back to 4.2% from a likely 10% peak by 2022. In contrast to the actions of other governments the New Zealand government has focussed on new job creation, the healthcare system and infrastructure. Too many countries are focussed on politically inspired payouts to households and maintaining employment in declining industries rather than recognising that the world has changed.

In the United States a fiscal deficit in 2020 of 19.5% will leave the government with total debt at 135% GDP. China is spending almost as much as the United states at 14.3% GDP which will lead that government at 74.7%. JPMorgan now expect global gross government debt as a share of GDP to jump to 108% in 2021 from 90% in 2019.

The huge rise in government spending sets a major challenge for governments when they turn into each new year. The 2020 global government fiscal thrust is to buy three percentage points of growth. However, ‘exhausted’ governments are set to retrench in 2021 providing 1.5% points of less support for their respective economies. Hence unless an economy has gained some momentum, current slated government spending plans risk pushing their economies back into recession.

Government hand-outs may be good charity in the near term however it does not encourage the resetting of an economy for the challenges at hand. As Japan has found to its cost constant government hand-outs just leaves your economy in a cycle of poor growth, and a never ending raking up of debt. Last week the US House of Representatives passed a bill for a further $3 trillion of spending – well-intentioned but not the long-term answer.

The open question is how do the respective ministries of finance around the world keep their bond markets well behaved in the face of such a staggering increase in issuance? In the US the 2-year- 30-year government bond yield spread has widened somewhat since mid-March but a current spread of 118bps is within the boundaries of normal.

Could consol bonds be about to make a comeback? Consol bonds were issued by the UK government in 1752 and didn’t disappear until 2015. They had many of the characteristics of perpetual bonds – the government could decide when to repay the debt. The UK government at the time issued the consols to consolidate its debt issuance and reduced its interest bill.

In Europe, where estimates for the cost to rescue an economy suffering from COVID fallout is reaching above EUR 1 trillion, the idea of government perpetual bonds has been mooted. The timing could not be better from a pricing point of view: with long-term rates in Europe hovering near zero, the annual interest cost would be low to non-existent. As perpetual do not redeem, the only burden on governments would be to fund the interest rate bill into perpetuity. Under other circumstances, such a course of action might run into ideological opposition, as it seemingly allows governments to borrow with impunity and go on an inflationary spending spree. Right now though, that is precisely what Europe and the US needs.

So, the governments and central banks may have a few tricks left up their sleeves to cap bond yields, QE, consol bonds. However, you sense that the moment of truth particularly in the US and Europe may not be that far away. At some stage you have to believe that governments will be obliged to increase taxes.

In economic theory the current conversation is about how much can the global bond markets tolerate free-for-all Keynesian economics, with mass government spending without hitting the Minsky moment where a loss of investor confidence sends bond yields spiraling higher. Hyman Minsky warned in the 80’s of the Ponzi nature of economic cycles. We are already witnessing serious distress in the credit markets (despite Fed support), where predicted default rates are starting to hit 10% the same ballpark as 2008/09. If we add a vast pile of government debt to the equation, the risk of a leverage-driven tipping point (Minsky Moment) is as big as ever.

The work from home challenge to real estate

A revolution in ‘working from home’ has the potential to be one of the defining new trends in the real estate sector in coming years. Some people can say that it has been tried before, but it didn’t work. However, this time the available technology has possibly made working from home sustainable, and a significant challenge for the real estate market.

IBM famously pulled the rug from working from home in 2017. However, that decision may have had more to do with new executive trying to ‘shake up’ things after 19 quarters of declining sales. In any case, by the time IBM took its decision, 25% of all US employees were already working remotely all or most of the time.

The difference with the work from home syndrome this time is that it is better empowered by technology. Internet speeds are quicker, video calls have become a normal mode of communication. Courtney Rubin in an article entitled “The Office is Dead” points to the prohibitive annual cost of office space in New York City which works out at $17,020 per employee. Companies are now cash flow poor and probably legislated to give their average office worker even more space around them… forget the open plan rabbit-hutch office designs of the past…… social distancing is here for a while yet.

Manhattan has 526 million square feet of office space with a 10% vacancy rate as of now. That is equivalent to approximately two Empire State buildings of spare office space. Even if just 10% of Manhattan office workers started telecommuting that would add another two Empire State buildings of spare floor space, let alone the impact for the rise in unemployment. In 2009 the vacancy rate on Midtown Class A office space rose to 15% and average rents for the same class of property was $73.10. Today the rent is $88.84. That’s rental growth of just 1.9% per annum in the recovery years – what will it be like now given the challenges?

The challenges to the REIT sector are very visible. Missed rental payments, potential declining demand for office space, a collapse in consumer spending. The Global REIT Index is down some 36% from its February high, probably already reflecting that the market is baking into valuations the challenges ahead. The sector is on an historic dividend yield of 7.9% but prospective of 5.7% implying a near 30% fall in dividends in the current year. We prefer to see it as a sector to watch but to be highly discerning in what you buy.

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