U.S. real estate market update—July 13, 2020

Given the mid-summer heat and COVID-induced lockdowns, it’s hard to believe that January 1, 2020 was only six months ago. Thanks to school cancellations, business closures, near universal work-from-home mandates, the introduction of “social distancing”, and much more, 2020 has introduced a “new normal” into almost every facet of our lives. Similarly, markets themselves have changed dramatically as the Fed has cut rates back to near zero, the 10-year Treasury yield is only about 10 bps away from its all-time low, and equities plummeted before surging back in the second quarter. Now that we’re halfway through 2020, let’s examine how we got here and what the second half of the year might bring.

2020 outlook as of January 1, 2020

The biggest threats are those you don't see coming

Generally speaking, the outlook for 2020 seemed to be relatively optimistic. Many of the risk factors investors were wary of (like hard Brexit concerns, U.S. / China trade agreement) were deemed to be either in the rearview mirror or expected to be resolved soon. Major U.S. banks’ research desks were projecting GDP growth to accelerate¹, higher wage growth¹, and for the U.S. consumer to remain well positioned to keep spending². The U.S. was still three weeks away from reporting its first COVID-19 case, and the market didn’t appear to be pricing in the threat of a wide-scale coronavirus outbreak in the U.S.

Market benchmarks

Selected hedging figures

Q1 review

Bad news on the doorstep

The first quarter started out relatively benignly before the fixed income markets started to react to COVID-19 headlines. Equities soon followed suit, dropping sharply in March. We seemingly couldn’t go a day without hearing two big buzz words:

1. Volatility: The S&P 500 went 40 days (February 12 to March 23) without consecutive “up” days. In the treasury markets, we had numerous 10 standard deviation moves, sometimes in consecutive days in opposite directions.
2. Flight to cash: Market lexicon graduated from flight-to-quality to flight-to-cash, as even short-term, cash-like instruments (like Commercial Paper) traded at steep discounts, leading to a major disconnect between the Fed Funds rate, which finished the quarter at 0.08%, and 1-month LIBOR, which finished at 0.99%. Investors explored several ways to access cash, including terminating hedges in asset positions and re-couponing existing trades, even if it meant being temporarily unhedged and/or accepting punitive discount factors.

Following positive January and February jobs reports, economic data started showing much more stress in March with 1.37 million jobs lost. GDP for the quarter was -5%.

Q2 review

A rebound?

Thanks in part to a slew of Fed guidance, Fed programs, fiscal support, mortgage relief, and more, we started to see some recovery in Q2 despite the worst jobs print in U.S. history coming in April at -20.7 million and unemployment reaching double digits for the first time since 2009 as lockdowns went into effect. Due in part to Fed intervention, market conditions normalized somewhat as the spread between Fed Funds and 1-month LIBOR narrowed, the demand for cash eased, and the margin call-sell-margin call-sell cycle broke.

The worst ever April jobs print was followed by the best ever for May, and then a new best ever for June. Along the way, equities enjoyed their best quarterly performance in a decade as investors seemed to price in both an effective, accessible vaccine sometime relatively soon and perhaps more importantly a broad-based return to normalcy in human/business activity.

Still, some investors worry about potential inflation and future growth in response to the massive borrowing done to support some of the recovery programs.

Where are we now?

How quickly things change – after a 5% drop in GDP in Q1, forecasts for Q2 GDP anticipate a -34% print³, a far cry from the positive GDP growth forecasted at the beginning of the year. The 10-year Treasury yield has fallen 120+ bps as investors bet we’re in another “lower for longer” period. Equities are down only ~4%, possibly due to fixed income, gold, and other safe haven assets becoming more expensive.

Similarly, the cost to hedge USD interest rate risk has fallen substantially. The same $100 million, 3-year, 2% cap that cost roughly $250,000 at the beginning of the year now costs about one third of that, at ~$80,000.

On the flip side, as USD rates fell, the percentage pickup to hedge EUR and GBP assets back to USD shrunk dramatically, with the pickup to hedge EUR still positive, but slimmer by nearly 150 bps. Likewise, the pickup to hedge GBP assets back to USD is still positive but is almost entirely driven by the cross-currency basis between the two currencies.

Market benchmarks

Selected hedging figures

Second half factors

Second wave and lockdown fears; will there be more stimulus?

What will be the key factors that drive the market in the second half? The most obvious might be the one we all see on a daily basis: will there be another lockdown? That edict may not come from the federal level, as state governors have started to chart their own course in response to their states being in substantially different states of health. Nationwide, over 70% of the population has seen the reopening process either halted or reversed. While lockdown decisions are likely to be made at a more local level, any fiscal response would come from the federal level, with the current chatter signaling that a second measure may come in August.

Geopolitical tension

One of the seemingly few things that Republicans and Democrats agree on right now is that they share an unfavorable view of China. The odds of full-out armed conflict seem remote, even with the U.S. moving two aircraft carriers into the South China Sea for military exercises. Nonetheless, without a traditional “hot” war, there are a number of issues that could shake markets including the Hong Kong law, the ongoing Huawei saga, alleged misconduct associated with the coronavirus outbreak, and the Phase 1 trade obligations.

Election uncertainty

There does not yet appear to be an overwhelming favorite yet in the Trump vs. Biden race. The market will carefully watch for each candidate’s vision on a number of factors, including the role of monetary policy (including potentially modern monetary theory), any fiscal plans, and their view on trade policy. Thanks to massive federal debt, a growing budget deficit, and already easy monetary policy, whoever wins may need to make unpopular decisions to restore finances.

If the market is already cognizant of the possibility of a second wave, geopolitical tensions, and election uncertainty, the key question may be “what is the market not pricing in?” In the first half it was COVID-19, and it turned 2020 into a year we’ll all remember. Please register to attend our Semiannual Market Update webinar taking place Thursday, July 16 at 2 p.m. EDT. We'll be examining current market conditions and Fed policy, hedging implications and considerations, and USD LIBOR transition, all within the context of the COVID-19 market.

¹ Source: Goldman Sachs 2020 US Outlook: On Firmer Ground

² Source: JP Morgan Global Market Outlook 2020: Higher Growth Outside of U.S., Lower Returns

³ Source: Bloomberg’s ECFC screen