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In this edition of Investment Themes, we focus on escalating fears over the health of the commercial real estate (CRE) sector amid fears over wider financial markets as well as the prospects of the dollar and what that means for asset returns going forward. 

Alpine Macro argues the financial system should be able to withstand a fall-out from CRE prices, Veritas assesses US bank exposure to CRE, NBER explains how the “donut effect” will have a profound effect on CRE markets, and TS Lombard warns as valuations correct, investors will have to pay closer attention to the level and nature of the risk imbedded in their real estate funds.

Meanwhile Eurizon SLJ explains why falling inflation could mean a 10 percent generalised dollar depreciation this year, and Pennock Idea Hub sets out what US dollar weakness may mean for asset returns.

In addition, Blonde Money traces the current brittleness of the financial system and its markets back to the collapse of the hedge fund Archegos in early 2021, and posits that this story has much further to run.

Alpine Macro: CRE loans – the next shoe to drop? (April 3)

The regional banking crisis has shaken confidence in the US banking system, says Henry Wu at Alpine Macro, who notes deposits continue to exit small banks. He says investors looking for the next shoe to drop have zeroed in on commercial real estate (CRE), to which regional banks have high exposure. Alpine Macro’s analysis shows that the financial system should be able to withstand a fall-out from CRE prices, says Wu. Nevertheless, there are several key risk factors that investors should keep in mind, he says. Click here for the full report. Click here if you would like to speak to the analyst.

Veritas Research: US Banks – CRE in focus (April 4)

Back in early March Veritas Investment Research produced a timely piece of research on US banks where they delved into 4,773 Federal Deposit Insurance Corporation (FDIC) filings to quantify the extent of unrealized losses on bank balance sheets based on their securities held either as Available-for-Sale (AFS) or Held-to-Maturity. That enabled them to quantify unrealised losses of $620 Billion. Veritas have now done a similar exercise on commercial real estate (CRE) and construction & development (C&D) to assess the exposure of US banks. Their report provides an expanded list of US banks with elevated exposure to CRE and C&D loans relative to key financial and regulatory metrics. CRE and C&D loan concentration alone does not necessarily signal higher risk, since underwriting risk and subsector risk vary, notes Veritas. Further, actual losses will be distributed unevenly, says the firm. However, precedent suggests that a bank with a higher CRE and C&D loan concentration, all else equal, will be more negatively impacted by a real estate downturn, according to Veritas. Click here for the full report. Click here if you would like to speak to the analyst.

NBER: The donut effect of Covid-19 on cities (December 2022)

This NBER working paper quantifies the effect of Covid-19 on migration patterns and real estate markets in US cities, and how changing working habits are impacting real estate markets. The authors explore the so-called ‘’donut effect’’ looking at city sizes and how that relates to the size of the ‘’donut’’, which essentially refers to the hollowing out of Central Business District. This phenomenon will have a profound impact on commercial real estate markets. Click here for the full report. Click here if you would like to speak to the analyst.

TS Lombard: Private Markets; Real estate – commercial constraints (March 22)

As valuations correct, investors will have to pay closer attention to the level and nature of the risk imbedded in their real estate funds, according to Andrew Lawrence at TS Lombard. As we emerge from artificially low to more historically average interest rates, private equity fund managers will no longer be able to acquire assets in the comfortable expectation that they will sell for a higher price in five to seven years’ time, he says. There will be significant opportunities at the end of this rate cycle, according to Lawrence, but between now and then, many private equity real-estate funds will have to stem the outflow of cash and reduce the amount of red ink on their quarterly reports. If the Fed rate rises cause a broad-based credit crunch followed by a recession, then private equity real-estate fund returns are going to be under pressure, he says. Click here for the full report. Click here if you would like to speak to the analyst.

Eurizon SLJ Research: Falling inflation to bring down the dollar (April 4)

Stephen Jen at Eurizon SLJ Research expects US inflation tideline at roughly the same pace as it rose in 2021 and the first half of 2022. As long as the world does not fall into a deep recession and inflation recedes on its own, the dollar would lose the cyclical support that has propelled it some 20 percent deep in overvalued territory vis-à-vis the G10 currencies, he says. As the dollar loses cyclical support, the US’ familiar structural flaws might again become exposed, as the supportive ‘tide’ recedes, according to Jen. These structural flaws include especially the usual ‘twin deficits,’ which have grown to historical size (around USD2 trillion), he notes. According to Jen, the key point to make here is that, consistent with his Dollar Smile framework, fading inflation with a soft landing should push the dollar into the deep trough of the Dollar Smile. This could mean 10 percent generalised dollar depreciation this year, and more next year, he says. Click here for the full report. Click here if you would like to speak to the analyst.

Pennock Idea Hub: What USD weakness may mean for asset returns (April 3)

The dollar index is testing support that stretches back to 2015, according to Cam Hui at Pennock Idea Hub, and if it were to break lower it would spark a secular bear phase and the dollar could face considerable downside potential compared to current levels. Dollar weakness is likely to spark better relative returns for non-US equities, he says. If the dollar were to fall into a secular bear phase, one asset that is also likely to benefit is gold, which has historically been inversely correlated to the dollar, adds Hui. In addition, he says commodity prices are sounding a warning that a recession is likely ahead, which would be bullish for Treasuries and bearish for cyclically sensitive assets like commodities. Click here for the full report. Click here if you would like to speak to the analyst.

Blonde Money: Archegos is the Red Flag – Part 3

As has been proven time and again, the origins of any systemic crisis, or market crisis, always exhibits similar characteristics, and always tends to play out over an extended period of time. Helen Thomas from Blonde Money has just written part 3 of her trilogy that traces the current brittleness of the financial system, and its markets, back to the collapse of the hedge fund Archegos in early 2021. She first wrote about this back in April 2021, and then again in May 2022, and in her latest piece she argues that disappearance of four banks in seven days can be traced back to the demise of Archegos. Thomas says momentum from Archegos and other ‘little flare ups’ in 2021 paved the way to last year’s quasi-default of the LME, the existential crisis in LDI strategies and the bankruptcy of FTX. The recent banking crisis is itself just the latest iteration of the same story: positions pumped up on huge liquidity that couldn’t exit due to the scarcity of collateral once the facts changed. Thomas connects the dots of all these events in this note and posits that this story has much further to run. Click here for the full report. Click here if you would like to speak to the analyst.