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It's the Inflation, Stupid – Lexology

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We certainly have an abundance of bad bits and bobs out there right now, don’t we? War, pestilence, chubby dictators with rockets, buff dictators without souls, miscellaneous threats to world peace. It’s everywhere. Nonetheless, my take remains (see my prior blog, Prognosticator’s Regret) that, at least for our economy, all that doesn’t matter so much (how stupid does that sound?). It’s only through the transmission mechanism of monetary change that our economy is really impacted and regrettably, we’ve got that in full right now in the form of rapid, material inflation.
There’s some comfort in knowing the occupants of the heights recently gave up the usage “transitory” to describe inflation, because that was a very tattered excuse for inaction. Now, at least, the Fed is talking the talk. Lael Brainard said last week that the Fed would begin to shrink its balance sheet and move the Federal Funds rate in a muscular way. Well, all that palaver is suggestive of a renewed seriousness of purpose, but the jury’s out on whether we are actually going to do what needs to be done and do it on the sustained basis necessary for success. Even if Fed policy begins well, and they’re really serious about reducing the $9 trillion balance sheet and moving the Fed Funds rate by more than a meager 25 bps per meeting, it may be too little and too late and they are not very likely to keep at it when the political winds begin to howl in their direction. A bad ending here has already been baked into the cake.
I need a plan! I wish I had conviction about what’s ahead. I’m sure, if I was an academic economist, a profession that bears a striking resemblance to astrology, a fact denied by many economists and almost all astrologists, I’d then be cloaked in the certainty characteristic of geeks with formulas (thank you, Mr. Buffet). Then I could be dismissive of anxiety, of uncertainty, of the natterings of all the apostates wringing their hands while the economic mainstream consensus seems to stick with the notion that things aren’t really all that bad… it’s all going to be okay. However, unlike economists and astrologists, I actually have to put real money at risk and not just write another Op-Ed. And I’m not buying it.
The fact that sussing out what’s really likely to happen in the next months and years is very hard is troublesome, but the fact it’s hard is not an excuse not to plan and act. The sort of rampant inflation that we are now seeing will change the calculus. While inflation is always a cyclical phenomenon, it’s a long cycle and long cycles are virtually indistinguishable from secular change whilst you’re enjoying the ride. It’s very cold comfort to know that inflation is cyclical and will end some day. Some day? As Lord Keynes said, “In the long run, we’re all dead.”
So, what to expect? My baseline assumption is for sustained inflation, stagflation really, and then a serious contraction and a hard landing. Inflation will stay too hot too long, surely above consensus estimates. This Administration, in thrall to the notion of being every man’s friend in a progressive sort of way and mindful of the upcoming midterm elections, and the perfectly understandable general distaste amongst the folk to ever pay the piper, will not be the adult in the room. History tells us that on the first whiff of powder, in the form of reduced economic performance, the clarion call will be …Runaway, Runaway! The Fed will retreat under enormous political pressure from the Administration, our gloriously elected representatives and broad swaths of the chattering class and will return to an accommodative stance (just for a little while, of course).
This is a prescription for anything but a soft landing. You know what’s going to happen from here, don’t you? You’ve seen the movie. After an unjustifiably long period of accommodation, we will first see a bit of economic rigor and then, presented with some evidence of a slowdown, accommodation will return to the scene. When the scale of an upcoming disaster can no longer be ignored and with the fiscal side of the government simply not capable of being serious and disciplined, the Fed will ultimately slam on the brakes. Monetary policy is a blunt instrument and the Fed has rarely engineered a soft landing before and, given the conditions of our economy right now, they won’t do it this time.
Consequently, a recession of some significant scale will follow sometime in the 12 to 18 months. How will the CRE finance world perform against this backdrop? First, given the complexity of economic incentives surrounding the finance world, it’s pretty clear that some not insubstantial segment of our business will still be driving the production race car at 200 mph until we all actually hit the bridge abutment. As one of our most prominent bankers said more than a decade ago when discussing the Great Recession in testimony to Congress… “As long as the music’s playing, I’ve got to keep dancing.”
For a while, interest rate change will trail inflation. Competition to put money to work will remain stiff. No one is really paid for caution. Hard evidence of economic deterioration will remain a set of trailing indicators and so, as long as one doesn’t peer too far into the future (say any time after lunch today), confronting the reality of a hard landing can be deferred, if not ignored. Okay, consumers may already be getting crushed by broad price inflation, but they’re still spending. Perhaps they’re spending the helicopter largesse of our government over the past several years, living off the enhanced savings and reduced credit card balances accrued during the pandemic.
The canary in the mine should be the multi-family and SFR space, but the supply constraints in those sectors may obfuscate the deteriorating ability of the folk to pay their bills. In the office space, the denouement will be delayed because of the long-term nature of most office leases. Industrial and space usage will stay strong, until it’s not. As long as you keep your eyes firmly on the road immediately in front of you, you won’t notice that the bridge is out. It’s the boiling frog thing, right? Recognition of and response to serious inflation and monetary disruption can be ignored…until it can’t.
At some point, the Fed will overshoot, money will become dear, credit will deteriorate, liquidity will evaporate and asset prices will fall. Combine that with an almost complete absence of amortization across virtually all aspects of the commercial real estate finance marketplace and we have a prescription for …an unpleasant event. Refis won’t work, borrowers will default, cap rate shocks will begin to spread through the economy, bonds will dramatically lose value, coupons will soar, warehouses will retrench, liquidity problems will abound and ultimately bank failures and failures throughout the non-bank sector will follow (you do remember the pandemic, say around May 2020, don’t you?).
Recognizing that the music is still playing and that dancing will go on, the smart money should at least start to think about the virtual certainty of a material, near-term discontinuous recessionary event. It’s out there 12 to 18 months from now. I know, unless you were in the business 14 years ago, you have only read about real and deep recessions. It’s way uglier than what the textbooks make it out to be.
What interim actions are actually doable right now? Regrettably, in a real-world sort of way, not much. One can socialize the base case with investors and customers. It’s time to pass on deals where the pricing is too thin. Maybe it’s time to look at inflation-adjusted pricing. (We just closed a bond offering with the CRE bonds tied to an inflation index. Maybe that should be a thing.) For lenders, it’s certainly not a time to give up on covenants and structure, because they are going to be needed when the workout occurs. Give a little on coupons, take a little on structure. For borrowers, the converse: trade some enhanced coupon for more flexibility. A little more time, a little more certainty on extensions, maybe even a built-in workout? It’s time to start managing warehouse exposures (on both sides). It’s time to shorten accumulation periods where the exit is securitization. It’s certainly a time to move aggressively to term SOFR as opposed to the now lagging compounded-in-arears SOFR pricing. The disconnect between term and spot is going to continue as long as an expectation of inflation continues and compound SOFR will underprice market risk. I know it’s brutal to build a business plan for playing with distressed debt before the distressed debt cycle begins (a lot of money has been wasted trying to time distressed debt cycles in the past), but there you are. It needs to be done.
It’s time to keep some powder dry.
If you can embrace a somewhat cautionary posture (without deeply offending shareholders, investors and risking continued employment), it’s time to do so.
And remember, there will be money to be made out there when the cycle turns. So, get ready. It’s time to fix the roof before the rain starts. Have some dry powder and have a clear-eyed approach to navigating through difficult economic times. Be ready to leave something on the table and put something away for those times.
It’s going to be quite a ride.
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