Real assets shielded by relative illiquidity
Investors in real assets have been shielded from the gyrations in stock prices and bond volatility characterizing the coronavirus panic that has taken hold over the last few weeks. The relative illiquidity of commercial mortgage loans (CML), commercial real estate (CRE), infrastructure, and other real assets is a barrier against panic selling. Investors in need of cash will typically liquidate stocks and bonds first as their markets generally offer comparatively more liquidity including transparent pricing. Moreover, many real asset markets are operating at mature-cycle equilibria characterized by high occupancy and utilization, solid cash flows and constrained new supply. We believe these attributes encourage investors to sit tight as financial market volatility progresses.
Recession risk is serious threat
We believe the more serious threat to real assets is the global recession that is almost certainly underway. Predicting the depth and duration of the possible recession is futile because of two unknowns: the pace of contagion, and government policies targeted to containment and remediation. Limiting contagion is crucial because a portion of virus victims develop life-threatening respiratory problems requiring intensive care and mechanical ventilators. Capacity to address these demands is constrained and countries that were affected first show how quickly the limits were reached and health care overwhelmed. To slow down contagion, some governments are imposing restraints on public gatherings with China's locking down the Wuhan population in their homes the most draconian. At the same time, schools and universities are cancelling classes and establishing on-line learning alternatives, while private sector gatherings such as conferences, church services, theatre, movies, travel tours and cruises, have been cancelled or postponed across a wide swath of the globe. In addition, businesses are requesting or requiring employees to work from home if their job responsibilities can be accomplished remotely. There is no basis for estimating how long these policies will be in place.
The shut-downs and cancellations are taking a bite out of the demand side of economic activity. We believe this will have a sizable negative effect on short-term economic growth—how long the impact will last will ultimately be determined by the path of the virus and the corresponding 'shut-in' reaction. The slow-down in the supply chain, especially intermediate goods used in manufacturing, is disrupting the supply side of economic activity. As of March 17, 2020, the Baltic Exchange Dry Index was down 43% year-to-date, indicating a massive decline in the global movement of raw materials.1 If the demand and supply disruptions prove to be short-lived, they might have little impact on the revenue flows that support real assets. Hope that the spread of the virus will peter out as the weather warms is the foundation of such short-lived positive scenarios. If longer-lived, perhaps as long as it takes to develop and distribute a vaccine, real asset revenues will be threatened. For CML, recession risk is focused on borrowers' capacity and willingness to make timely payments. For property investors, recession risk is focused on the potential decline in occupancy, property revenue and ultimately property value. Other real assets are exposed to similar recession risks as shrinking economic activity eats into revenue flows and valuations.
We believe recession risk is not uniform across real assets largely because some revenue flows are more durable than others. For CML and CRE, hotels are most exposed as travel is plummeting; recreation venues such as theatres, convention centers, and stadiums are similarly exposed. Apartments are least exposed as tenant mobility is constrained. For all sectors, lease-up of new construction will likely slow reflecting enormous uncertainly.
Government action is crucial
Beyond government policies directed to limiting contagion, fiscal and monetary policies targeting the recessionary effects of the virus are of immense importance. Policies differ by country. In the US, the Federal Reserve (Fed) cut the federal funds rate to zero in two emergency moves. In addition, the Fed is injecting liquidity into the financial markets, backstopping commercial paper, and resuming the quantitative easing through securities purchases that was developed after the 2008 financial crisis. The Fed is also encouraging lenders to "use their capital and liquidity buffers to lend and undertake other supportive actions in a safe and sound manner."2
Monetary policy can address only a portion of the recession risk related to the virus. It cannot replace the income lost to consumers and businesses. Fiscal policies are required and are in process. Congress is working on a third package of fiscal relief which will include support for hard-hit industries such as airlines and hotels, and support for small-and medium-sized businesses. A wider policy to provide income support for consumers is also under discussion. Income support is especially necessary for individuals who have no access to unemployment compensation. Packages constructed earlier this month include funds for vaccine development and public health activities, funds to aid international efforts to control contagion, expanded unemployment compensation, some paid sick leave requirements, and funds for food support. The ultimate dimensions of both monetary and fiscal policy cannot be predicted and will depend on the path of contagion and its negative economic impact in the weeks ahead.
In the UK, the Bank of England cut the funding rate earlier this month in the face of an already flat growth performance. Support for short-term lending and a counter-cyclical buffer were also announced. Efforts to shut-down gatherings and impose distancing are under discussion. Policymakers considered letting the virus follow its natural course before rejecting that approach earlier this week as new research vividly advised against it. Further policy will be forthcoming.
On the continent, the European Central Bank (ECB) is providing additional liquidity to support banks and money market operations in coordination with the Fed and other international monetary authorities. Interest rate policy has not changed as the ECB's refinancing facility is already at the zero boundary. Individual Euro-zone countries are responsible for their own fiscal policies and requirements for activity shut-downs. Italy has been most stringent given the wide spread of the virus and the extreme disruption of the Italian health care sector. Authorities have put Italy on lock down.
Watch for opportunity
In our view, the best advice for investors in real assets is to sit tight. Real asset investments have always been marketed as long-horizon assets reflecting their relative illiquidity. Over the long-term, the virus and its disruptive economic impact will pass into history and growth will resume. In the interim, some investors will be unable to hold on and their assets will become available at attractive prices. The challenge for investors with dry powder will be to avoid buying too soon. The final watchwords for real assets investors are patience and forbearance.
1Bloomberg Barclays, March 16, 2020.
2Federal Reserve Press Release, "Federal Reserve Actions to Support the Flow of Credit to Households and Businesses," March 15, 2020.
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