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The weekly note

FEBRUARY 22, 2024

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This Week’s Developments in the US Economy

The Implications of a Potential Fed Pause and a Review of Key Indicators

During the most recent meeting of the Federal Open Market Committee (FOMC) on Tuesday, May 3, Federal Reserve Chair Powell signaled a potential pause in ongoing rate hikes. Mr. Powell acknowledged that the previous ten consecutive interest rate increases, combined with the impact of tightening credit conditions related to the collapse of regional banks in March and April, have brough policy to a sufficiently restrictive position needed to achieve a 2% target, albeit over some time. However, in acknowledging that it will take some time “for the full effects of monetary restraint to be realized, especially on inflation,” it seems clear that understanding whether policy is sufficiently restrictive—or perhaps overly restrictive—cannot be known until policy lags can be measured.

In order to gain a deeper understanding of the changes and momentum of crucial economic indicators that the Fed is likely monitoring for policy effects, we categorized a variety of indicators based on their impact areas (i.e. price, sentiment, and economic momentum) and assessed their annualized pace of change over three-, six- and twelve-month periods. To align with the Fed’s policy targets, for example, we view rates of change below 2% as “positive”, between 2% and the Fed’s year-end projection of 3.5% as “neutral”, and anything above 3.5% as “negative”. The results are illustrative of the potential for a long road ahead given the Fed’s repeated commitments to achieving a 2% target over time.

This Week’s Developments in the Global Economy

Euro Area Real Estate Declines Weigh on Regional and Global Banks

In the wake of recent turbulence within the banking sector, fueled by escalating worries over the resilience of select US commercial real estate sectors (“CRE”), we see Euro Area CRE experiencing similar signs of stress, which has impacted banks with meaningful exposure to both regions. This emphasizes the heightened risk perception shadowing global financial institutions, some of which have pared exposure to CRE in the US, UK, and EU over the last few years. As we touched on this briefly in October 2023, we examine in greater depth the state of the European CRE market and bank exposure, highlighting the interconnectedness of global real estate markets while also illustrating emerging opportunities in a dynamically shifting landscape.

European Bank Exposure & German Lenders

European banks hold approximately 1.4 trillion euros ($1.5 trillion) in CRE loans, with a significant portion originating from French, German, and Dutch domiciled banks. According to the European Central Bank (“ECB”), roughly 10% of loans in the Euro Area are derived from CRE. While most EU banks have limited exposure to US CRE, a select number of German banks stand out as an exception. Deutsche Bank alone has 17 billion euros allocated to US CRE markets, accounting for over 3% of its books and one-fifth of the 76 billion euros lent to the US by EU banks. Due to its size as the largest bank in Germany, Deutsche Bank may not feel the impact of these loans to the same extent as smaller banks. Nonetheless, last quarter the bank’s provisions for losses in US CRE quadrupled compared to the prior year, which may signal the potential for elevated risks. Similarly, another major property lender, Deutsche Pfandbriefbank (PBB) has 5 billion euros, representing 15% of its loan portfolio, tied to US CRE. PBB recently doubled its existing risk provisions, indicating preparations for potential loan defaults and contributing to investor concerns and subsequent declines in both share and bond prices.

Distress in European Commercial Real Estate

Decreased demand in select EU CRE sectors combined with increasing borrowing costs have weighed on European CRE valuations. While potential rate cuts by the ECB this year could offer relief, recent data, particularly decelerating wage growth, has been promising but in our view is unlikely to be sufficient to motivate cuts in the near term. Thus, we believe to see continued negative pressure on valuations amid elevated rates. This concern is underscored by the negative net flows observed in European property funds for 11 consecutive months and, as highlighted in our October 2023 note, 40% of euro area CRE markets is associated with Real Estate Investment Funds (“REIFs”). Further exacerbating the situation, according to MSCI, European CRE transactions in Q4 2023 saw the lowest year-end figures in over ten years, with a 43% decline in volume year-over-year. Additionally, the Green Street Pan-European Core Sector Commercial Property Index also reported a 10.9% year-over-year decline in CRE values in January 2024. These trends, marked by diminishing values and reduced transaction activity, highlight meaningful secular risks, indicating a lack of foreseeable recovery in the European CRE market in the immediate future.

German Commercial Real Estate

While German banks have experienced stress due to CRE exposure, German CRE also stands out relative to European CRE overall, experiencing some of the more severe distress characterized by halted property deals, stalled construction projects, and insolvencies. According to Verband Deutscher Pfandbriefbanken’s (“vdp”) property price index, CRE prices in Germany saw a decline larger than that of the Green Street’s Pan-European index in the fourth quarter of 2023 at 12.1% year-over-year, with office properties driving the headline figure with a 13.3% decline year-over-year (see accompanying visual). The retail sector and multifamily properties also witnessed a notable decrease at 9.0% and 6.3% year-over-year, respectively. According to vdp the annual growth in multifamily rents nonetheless remained unchanged at 5.8% from the previous quarter, significantly surpassing the 3.6% average observed during the period from 2010 to 2019.

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Market Rates, Catalytic Indicators, and the Week Ahead

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