Last month saw the first huge correction in the stock market since early 2016. US Congress agreed on an expansionary spending path for 2018-19 and long-term interest rates increased to multi-year highs and are expected to increase this year. How will this play out in the real estate market? Although it appears to have been mainly technical factors that triggered the correction in the stock market, inflation concerns have been the major cause for plummeting stock market prices. We have outlined such a scenario of inflation and its impact on real estate investments. Indeed, the difference between current and trend economic growth is moving close to zero, rising labor demand is putting upward pressure on wages and salaries, but it is still far from a strong acceleration in inflation rates. Meanwhile, the recommendation by the US Department of Commerce in its investigation to restrict aluminum and steel imports on national security grounds is a reminder that the risk of escalating trade tension has a significant impact on real estate investments. We are not suggesting that the probabilities of risks have risen substantially in light of these events.
However, we argue that higher volatility combined with uncertainties about the future uncertain outlook for US trade policy is not an environment where we should risk everything on one endeavor, but rather seek returns by pursuing opportunities in the real estate market. It would be more than natural that unjustified price appreciations will be corrected over time. Some observers believe that rising inflation may have played a prominent role in the recent stock market sell-off. However, higher inflation points to an overheating economy and rising wages could lower profit margins. Neither case obviously applies at the current time. However, historical evidence shows that periods when inflation begins to rise often create volatility in real estate markets and, on average, returns are meager. Finally yet importantly, higher interest rates could hit real estate prices if they reflect rising risk. Higher interest rates should be less relevant if they result from higher growth. For now, we expect the implications of rising interest rates on the real estate outlook to be limited. A more persistent significant decline in real estate prices could, however, be associated with somewhat slower growth, either because the economy anticipates a slowdown, or because economic decline itself dampens growth. The impact of rising interest rates on growth also depends on the factors that pushed up interest rates. The rise in interest rates could be the consequence of stronger growth momentum, in which case the economic fallout is understandably limited.
However, if higher interest rates reflect rising risks, for instance, then growth may well suffer more significantly. Financial conditions remain very loose and interest rates relatively low. This should continue to support economic growth. Therefore, we are keeping our scenario of sustained economic growth: (1) higher world economic activity, (2) rising fixed capital formation, (3) a very gradual adjustment of monetary policy in the US. We acknowledge the risks from higher protectionism, as recent announcements are a reminder that trade frictions could escalate significantly. At this point, it remains to be seen what action the US will take and how other countries may respond. Since the beginning of the Great Recession in 2008, most have averted the specter of deflation by deploying conventional and – even more importantly – unconventional measures of monetary policy. Inflation in the US averaged around 1.5%, with a dispersion of -2% in mid 2009 to approximately 3.8% in late 2011. Currently, US consumer price inflation stands at 2.1%. In the US, the government is embarking on a path of fiscal stimulus, and more trade tariffs and trade friction may push inflation higher.
However, several factors are keeping underlying inflationary pressure contained for now, including still-cautious wage bargaining behavior by households, price setting by firms and compositional changes in the labor market. In addition, the recent readings have likely overstated current price trends,( the surprising weakness in inflation in 2017). Outside the US, wage and price trends have not changed much in recent months. Against this backdrop, we do not foresee any surprises over the course of 2018. The Fed is expected to gradually lift rates with caution depending on the tightness of the US labor market, the evidence of accelerating wage dynamics and the potential impact of higher financial market volatility on economic growth. In addition, a tax policy that fosters the competiveness of Corporate America and attracts direct foreign investments, helping to raise the potential growth rate of US, should also be supportive for the greenback. At the same time, there are as many factors pointing to a glorious future for real estate markets According to the Federal Reserve Bank of New York, the current probability of recession for the US economy stands at around 4%, moving to approximately 10% at the end of 2018. In our view, the gradual tightening of monetary policy, limited inflation expectations and cautious investment demand, will keep real interest rates relatively low. Therefore, we prefer real estate investments in 2018. ABOUT THE AUTHOR: Eugene E. Vollucci is the Director of The Center for Real Estate Studies, a real estate research institute. He is author of four best selling books and many articles on real estate rental income investing and taxation.