COVID, Inflation, and Urban Real Estate

September 10, 2021. Young People, Moving Back to the City, Have to Live Somewhere.

Sep 11, 2021

Summary

After 18 months of battling COVID, 70% of U.S. adults have received at least one vaccination and businesses are gradually re-opening their doors to customers. GDP has recovered back to pre-COVID levels, wages and prices are rising and businesses are scrambling to find candidates to fill 11 million job openings. Government support programs are being phased out. The headline issue is now inflation. This fall, the Federal Reserve (Fed) will likely begin to cut back its monthly purchases of bonds and mortgages from $120 billion to zero by the end of next year, a major risk to sky-high stock and bond valuations.

Cities are springing back to life, even faster than I suggested in my urbanization paper earlier this year (Rutledge, 2021b). Cities were initially hit hard by COVID, as frightened people moved from the city to the suburbs. But now, people are moving back to the cities in record numbers, which has reduced apartment vacancies and pushed rents higher. So far, massive government support programs have prevented meaningful forced sales of commercial properties. The end of COVID relief and reversal of Quantitative Easing should change that and produce interesting buying opportunities later this year and in early 2022.

The Mouse and the Cheese

It’s tough to be a patient, disciplined, fundamental investor today. We all know that stock and bond prices are too high, but we don’t want to sell while prices are still rising. We all know that buying assets when prices are high leads to low returns. We all know that stock and bond prices are high: 1) because people believe that inflation will remain low; and 2) because the Fed is buying $120 billion worth of bonds and mortgages every month. And we all know that one day soon some piece of news will trigger the mouse trap and stock market investors will get caught reaching for that last piece of cheese. That “something” will be evidence that inflation is here to stay and that the Fed has flipped from buying bonds to being a seller. Long-term investors would be wise to establish a significant real estate allocation before that day arrives. I will discuss which type of real estate offers the best value later in this piece.

Macro Storm Systems

Market swings across asset classes today are dominated by macro headlines—employment reports, ISM reports, central banker utterances, regulatory announcements, and whatever Xi Jinping doesn’t like today—which makes individual daily stock price movements both volatile and tightly clustered around macro themes. This makes diversification more important than ever and strengthens the case for a larger real estate allocation to protect capital against steady erosion as inflation rises.

In this environment we need to pay special attention to the impact of changes in macro drivers on our portfolios. I normally have several macro themes working at the same time in my personal portfolio. I think of them as keys on a piano that I use to increase or decrease exposure to different sources of risk and opportunity. I laid out the analytical model behind this approach earlier this year likening major macro events to storm systems on a weather map (Rutledge, 2021a).

Before we can address investment issues, however, we must understand where we are in the evolution of the COVID pandemic. COVID is still the overriding backdrop to all global macro themes. We still read headlines every day about new case numbers, new variants, new advice from the CDC, and new mandates from federal, state, and local governments. People, suffering from lockdown fatigue, seem to flip between “Armageddon” and “All Clear” postures with each piece of news, producing wild daily swings in stock prices. But the truth is messier than that. We are past the worst of the pandemic in the U.S., but COVID is going to be with us for a long time.

The COVID ecosystem is best described as a complex adaptive system comprised of the dynamic interactions among three classes of agents—the COVID virus, COVID hosts (people who have had COVID or are susceptible to infection) and governments and businesses attempting to mitigate COVID’s effects. Each action by one of the agents triggers reactions by the other agents, with unintended feedback effects.

Today, eighteen months into the pandemic, these dynamics have produced multiple mutations of the initial virus and multiple waves of infections. Most people are aware of the four major variants currently on the CDC’s “of concern” list (Alpha, Beta, Delta, Gamma), but the CDC has identified another half dozen variants on their “of interest” list (CDC, 2021). And the WHO is keeping track of 11 additional variants on their “alert for further monitoring” list (WHO, 2021). Unless we speed up vaccinations, we may blow through the entire Greek alphabet by Christmas.

Once the genetic structure of COVID had been identified in early 2020, scientists were able to develop and produce safe, effective vaccines at breathtaking speed. Sadly, it has taken longer to get people to use the vaccines than it took to create them. Most developed countries have now made good progress in vaccinating their people. Many emerging economies in Africa, Asia, and Latin America with no access to vaccines, have not been so lucky. And then there are the anti-vaxxers, whose antics are slowing the vaccination process, which gives the virus more opportunities to mutate into new variants.

We are going to see many more waves of rising and falling cases before we are done. Hopefully, each wave will be smaller than the one before but each one will be a surprise to most people. The waves will be bigger in the developing world than in the rich countries, but viruses have no respect for national borders. We are certain to see repeated sequences of outbreak, lockdown and reopening with attendant supply chain disruptions of the sort we are experiencing today in microchips, auto parts, and shipping containers. Each time that happens the economic numbers will go haywire again, people will get scared, and we will see another wave of buying opportunities.

I first started studying agent-based epidemiology models of epidemics more than three decades ago due to my interest in the mathematics of complex adaptive systems. I remember being puzzled to learn that epidemics are rarely one-and-done affairs; they typically generate repeated waves of outbreaks, sometimes years apart, no matter what policy measures are taken to prevent them. With notable exceptions for smallpox and polio, both eradicated by mandatory universal vaccination programs, this pattern shows up throughout the history of disease at least since the plague in Greece during the Peloponnesian War, as I reported in a recent paper (Rutledge, 2021b). COVID will be no different.

With this as the backdrop for investing, here are a few of the more important storm systems I am tracking. I will start with urban real estate, the most interesting of them all.

Urban Real Estate

The COVID dynamics described above make urban real estate especially interesting. COVID initially drove large numbers of people from the cities to the suburbs, with profound impacts on vacancies and rent in the cities, and on home prices in the suburbs. That led many to predict the demise of great cities like New York and San Francisco. But young people want to live and work in the city. For reasons I outlined in a white paper on urbanization (Rutledge, 2021b), there is a mountain of historical, economic, and scientific evidence showing that, once a pandemic has subsided, people invariably migrate back to the city. This pattern of outflow followed by inflow creates attractive opportunities for urban real estate investors.

The chart, above, shows rents in six major U.S. cities since the beginning of COVID. As you can see, the exodus from the city that increased vacancies and drove rents lower during 2020 has already reversed itself. Young people are moving back to cities in large numbers, which has produced a bidding war for vacant apartments and a spike in leasing activity that has pushed rents sharply higher.

The office story is a little different, as shown in Figure 3. Although people have shown that they want to live in the city, they have been slower to show that they want to go back to work again. At this point, only about one-fifth of the offices in New York are being used on a given day.

New Yorkers are also not yet comfortable using public transportation. As you can see in Figure 4, New Yorkers are just beginning to ride the subway again.

The recent spike in delta-variant cases is likely to make the return to the office even slower, and more drawn-out. Microsoft, Amazon, both recently delayed return to the office plans until January.1 A growing list of companies (including Google and United Airlines) and government agencies are making vaccinations mandatory for all employees, which will help. But behavioral experts warn that it may take a year or more for COVID fear to wane sufficiently to get most people back to the office and that employers may need to take a series of baby steps to make it happen (Ariely, 2021). But it is a question of when, not if, people will return to the office. At the end of the day people are both happier and more productive when they work together.

The hotels and restaurants in the urban hospitality sector were hit even harder by COVID than apartments and offices, with dramatic drops in hotel occupancy rates. When people ultimately return to the office, the hotels will fill up again too.

The sharp drop in occupancy and cash flow during the pandemic and improvement in operating performance as people return to the office should create some interesting opportunities for investors to buy prime assets at discount prices. To date, massive government stimulus efforts, mandated moratoriums on foreclosures and evictions, and Fed buying of mortgage securities successfully deferred any system-wide selling pressure. When the stimulus programs are phased out later this year, however, we are likely to see more distressed-seller opportunities in major cities. And growing signs that inflation is becoming a bigger issue gives investors an additional reason to hold urban real estate as an inflation hedge.

Return to Growth

As I have written before, 2020 was not a “recession”, it was an economy-wide work stoppage—something like a massive labor strike—that happened because people couldn’t, or wouldn’t, go to work. The work stoppage caused GDP to collapse in the first half of 2020. The collapse of employment and output scared government officials into injecting trillions of dollars of income into the bank accounts of people and businesses, and the Federal Reserve turned on the Quantitative Easing firehose again, gobbling up almost $5 trillion of bonds and mortgages. The result has been the easiest financial conditions on record and a dramatic rebound of GDP.

Now that roughly 70% of adults have been vaccinated, businesses are re-opening and people are going back to work, which produced a huge jump in GDP in the first half of this year. As a result, GDP today is back to roughly where it was before COVID. Although income support measures are being phased out, US households are still sitting on $2.5 trillion of extra cash in their bank accounts compared with pre-COVID levels. That will pay for a lot of trips to Home Depot and will stretch out the recovery by making people a little pickier about reentering the labor force and going back to work, one of the reasons there are almost 11 million job vacancies today.

The huge drop and rebound of employment, incomes, and output caused by the pandemic has been hard to describe and even harder to measure. The national income accounts and other standard metrics for economic activity were designed for measuring small changes around “normal” and are of little use in describing what we just went through. The safe bet today is that output will continue to grow as businesses work through supply chain issues and people either get comfortable going back to work or run out of cash. This will be interrupted from time to time in different locations by further outbreaks and protective measures, but they are not likely to be big enough to reverse the rising output trend.

China

There are two important China issues. The first is the Chinese economy. China was the only major country with positive GDP growth in 2020. Urban incomes are still growing by 6-7% per year. And a significant share of the stimulus money people spent at Home Depot found its way to China as increased imports. Yes, the COVID outbreak in Ningbo will worsen shipping delays and reduce Chinese growth somewhat for the rest of this year. Yes, China has problems with too much corporate and municipal debt and a property market that blows hot and cold. And yes, the erosion of Chinese credit that accompanied the government crackdown on fin tech usage has slowed economic activity in recent months. No, the Chinese economy is not going to collapse.

The second issue—the political and economic decoupling of the U.S. and China—is much more important. It has been going on at least since Xi Jinping came to power in 2012. The Trump Administration’s tariffs, the punitive measures against Huawei and arrest of its CFO (whose father is a close friend of Xi Jinping), and the U.S. blacklisting of China’s three biggest telecom companies have all made it worse.

The situation has materially worsened over the past month due to the Chinese government’s heavy-handed regulatory actions against U.S. listed tech and education companies and restrictions imposed on Chinese companies hoping to do IPOs abroad which erased a trillion dollars of wealth in just four weeks. The U.S. added to the tension with a series of provocative steps regarding Xinjiang, Hong Kong, Tibet, and Taiwan, ending by announcing the sale of three-quarters of a billion dollars in weapons sales to Taiwan.

This is an extremely difficult position for investors. It would be foolish to expect that U.S./China tensions will improve soon. Investors without an inside track on developments in China should stay away for now. Those who feel knowledgeable enough to own Chinese shares should do so through the Hong Kong market, not via U.S. listings.

Defense stocks also offer a way to offset some of the China risk in a portfolio. The recent worsening of relations will create pressure to increase defense spending by the U.S. and our allies. The shift of U.S. strategic focus from the Middle East to China will also change the nature of defense spending—fewer Humvees, more air and sea power— which bodes well for companies like Lockheed, Raytheon, Northrop, and General Dynamics.

5G, Semiconductors, Data Storage

The U.S. has attempted to hobble Huawei’s efforts to build 5G telecom networks around the world both by denying Huawei access to key components manufactured by U.S. companies and by lobbying other countries not to purchase Huawei products. This has shut down Huawei’s sales in many developed countries but has been less successful doing so in the developing world where China’s One Belt One Road initiative has been very beneficial for Huawei’s network sales. The net result has been a 38% drop in Huawei’s revenues over the past year. In countries where U.S. efforts have been successful, it has created a big opportunity for Ericsson and Nokia, Huawei’s competitors in network equipment, and for Samsung and Xiaomi in handsets.

Virtually all future economic growth is going to be driven by fast information flows that require high-speed, low-latency 5G telecom networks to function. Low latency—very short delays between outgoing and incoming signals— is especially important for autonomous vehicles for safety reasons. Low latency requires both fast networks and short physical distances between end users and the servers that process data. That will require physically locating equipment close to the customer’s point of use, which will require a lot of new equipment and a network of widely-dispersed data centers to store and transmit information as well as telecom networks to deliver the information.

5G telecom networks, your mobile phone, your car, your home alarm system, and every other product that processes information or makes computations, run on semiconductors. That makes access to the most advanced semiconductors a key geopolitical concern.

Growing tensions between the U.S. and China have made Taiwan the epicenter of global political risk. Semiconductors are designed by companies in many countries but the foundries that physically produce them are concentrated in Taiwan. More than half of global supply is manufactured by a single company, Taiwan Semiconductor Manufacturing Company (TSMC), whose U.S. contract customers include Apple, Qualcomm, and Nvidia (Lee, 2021). Ironically, the U.S. blacklisting of SMIC, China’s top semiconductor producer, has made Chinese leaders focus even more intently on Taiwan.

Semiconductors are in extremely tight supply today due to both increased demand for electronics during COVID and supply chain disruptions. I believe conditions will remain tight for at least the next 2 years. New government programs are making money available to build manufacturing capacity in the U.S.. Much of that capacity will be built by TSMC and Samsung because they are the only manufacturers capable of manufacturing the most advanced chips. I believe that a moderate portion of a portfolio invested in leading microchip designers and producers, like a position in defense stocks, is a valuable hedge against further deterioration of U.S./China relations.

Summary

The COVID pandemic of the past year and a half has left investors emotionally drained. The near freeze up of the Treasury bond market in March 2020 and collapse of GDP in the following quarter triggered a firehose of fiscal stimulus and unprecedented purchases of bonds and mortgages by the Fed that continue to this day. The combined stimulus measures kept many households and businesses afloat and fueled the extraordinary recovery of GDP over the past year. It also artificially inflated bond, stock, and home prices to unsustainable levels. Household and business bank accounts today are still $2.5 trillion higher than their pre-COVID levels, which suggests continued growth but strengthens the case that inflation will remain high enough to force the Fed to take away the punch bowl by slowing, or even reversing, its purchases of bonds and mortgages in the face of huge Treasury borrowings to finance expenditure increases for new programs.

In this state, investors tend to overreact to each piece of good or bad macro news, which has resulted in unusually large daily moves in stock prices that often seem unrelated to fundamentals. I expect this increased sensitivity to macro factors to remain as long as prices remain high. The most important macro factors on my radar screen today are:

1) COVID. The delta wave we are experiencing now won’t be our last. It is the nature of epidemics to do repeat performances, with each wave hopefully smaller than the ones before. The arrival of each new wave is sure to scare investors into growth and inflation worries again.

2) Urban real estate. Rumors of the death of cities have been grossly exaggerated. Young people will continue to move back to the city, which will surprise skeptics and create interesting opportunities in urban real estate. Urban residential will be the first to recover. Offices will take a little longer, as will hospitality but their dramatic improvement in operating performance will make them extremely interesting for investors. If there is a meaningful tightening of bank lending after the stimulus programs have been withdrawn, leading to forced sales by current owners, this opportunity could be extraordinary.

3) Growth. Eleven million job vacancies make a strong case for continued growth. When investors panic with each new piece of bad COVID news by selling top quality growth-sensitive stocks, I will bet against them.

4) Inflation. Supply chain shortages will be with us for at least two more years. When they are gone, inflation will remain elevated. That means the days when the Fed was the investors’ friend are over and makes me want to avoid duration risk by shortening bond maturities and increasing my allocation to real estate and other tangible assets that offer inflation protection.

5) China. Chinese growth is slowing but the real China risk for investors is continued U.S./China decoupling and rising geopolitical risk in Asia. Until this changes, I believe that Chinese stocks, bonds, and private equity assets are too risky for most investors’ portfolios. Defense stocks can provide some protection from this risk.

6) 5G, semiconductors, data storage. The most dependable macro theme for long-term investors is continued acceleration of information flows to drive global growth. This includes businesses driving the continued rollout of high-speed, low latency, 5G networks, designers and manufacturers of the semiconductors that make them go, and the proliferation of secure data storage facilities that store the information that drives the next generation of products and services.

Dr. John

Dr. John Rutledge: Far from Equilibrium Economics

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