Once bitten, twice shy.
For those riddling your one-time, 1980’s MTV-addicted brain, I’ll save you some time. That was Great White. Not Whitesnake. Not Poison. Late Boomers and Gen X, keep your hair bands straight.
We’ll get to that connection in a moment, but first the data and the market sentiment.
Even though U.S. equity markets remained near their all-time highs as of late February, there are potholes in the U.S. bull market narrative everywhere at the end of February.
Let’s start with the sell offs. U.S. private equity firms’ share prices plunged in February as investors became more concerned that these firms were sitting on piles of losses on risky, private corporate loans. The trigger was major player Blue Owl ‘gating’ redemptions, but there were other reasons, including JPM CEO Jamie Dimon reiterating that lending discipline in the PE loan market had become lax.
PE was not alone, however. Investors rotated out of software stocks as several big names saw their shares plummet over concerns that AI would eliminate the need for SaaS. Salesforce, Oracle, even Microsoft all sold off sharply in February.
(Ironically, the market indexes were ‘saved’ by investors plowing money into stodgy utility and consumer staple stocks. PE multiples in those sectors expanded in February keeping the overall indexes supported. But this is not a recipe for long term support as we learned in 2000. Look out below).
In addition, investors saw a big dip in the stock prices on major U.S. brokerage firms like CBRE and JLL. (Disclosure: I was a buyer of CBRE on the sizable dip).
On the data front, there were a few things to like, but a lot to not like. On the positive side, a benign CPI print and a better-than-expected jobs number were encouraging. But the negatives offset the positives and then some. Higher-than-anticipated PPI and disappointing U.S. GDP underscored the fragility of the inflation and strength-of-the-U.S. economic narratives. In addition, consumer confidence and homebuilder sentiment remain anchored near New York Jet fan levels.
Geopolitically, instability resurfaced, with violence in Mexico and U.S. air strikes in Iran adding to investor unease.
Add that all up and you’d say there are more brown spots than green shoots in the investor landscape today than a month ago.
The Systemic Risk Story Returns
That brings us back to the opening line: Once bitten, twice shy.
Until the live shooting began in the Middle East, the most talked about story in February was the PE loan crisis. PE was sitting on a boatload of bad loans; that their share prices had been inflated by an unwillingness to write down values; and that these problems were going to become systemic.
Sorry, but we’ve seen this story far too often.
In 2015, the oil nosedive from $100 a barrel to under $40 a barrel was sure to make some over levered hedge fund break and spread to a system-wide contagion (I broke down what the 2015 oil bust teaches us about today’s private equity jitters in a recent Market Read).
In 2016, losses by loan makers to small oil and gas firm was sure to blow up some over levered leveraged loan maker and with the losses spreading to lenders’ lenders (banks).
In 2020, surely COVID would lead to a spate of bankruptcies as a result of U.S. consumers not being able to pay their bills.
In 2022, war in Ukraine would become the end of the U.S. recovery.
In 2023, higher rates would certainly cause some over levered entity to blow up, and the failure of Silicon Valley Bank would lead to 50 bank failures (or was it 500?) in 2023.
The lesson learned here is that none of these stories led to systemic problems for the U.S. Yes, in 2016, the Houston office market and small O&G shale players were smacked. Yes, in 2020, JC Penney filed for bankruptcy. Yes, after 2020, we saw big losses on U.S. office loans. And yes, in 2023, borrowers that used floating rate debt to buy value-add multifamily projects at peak values and rent-growth expectations lost their shirts.
But at no time did we see the late 1990’s Long Term Capital or the 2008 Bear Stearn/Lehman Brothers story. In 2008-2010 we saw those firms – along with more than 300 U.S. banks, AIG, and FNMA and FHLMC – done in by excessive risk taking and overleverage. That crisis certainly became systemic.
Since then, lenders seem to have found religion. Banks maintain more capital (regardless of the fact that a shotgun wedding with U.S. regulatory was necessary); lending discipline – at least in CRE – has mostly held; and investors are appropriately rewarded for the risks they take.
To be sure, for many of those periods, we fully expected something to break: an overleveraged LTCM redux would certainly take someone out – leading to the need for a bailout. But that never really happened. (The closest we came was the SVB failure, after which we got more QE and a de facto nod that not just ‘too-big-to-fail’ banks’ deposits would be insured. All bank deposits would be insured. At least, that was the lesson learned).
So, forgive us if we don’t join the chorus of those that are claiming the losses in PE will take down the U.S. financial system or require another U.S. bailout.
Could risk premiums widen from here? Certainly.
Will Steve Carrell, Christian Bale, and Ryan Gosling reunite for the Big Short II? Don’t hold your breath.
Where Does that Leave CRE?
On the data front, the first two months of the year have been solid. The LightBox CRE Activity Index for January – a forward-looking view of CRE sales and lending velocity – opened the year with its second highest level in three years and up 28% year over year. Sizable sales transactions remained elevated.
While equity markets fixate on systemic risk, CRE activity has quietly firmed.
Over the last two weeks, in our weekly market commentary – we presented two potential short-term outcomes for CRE. Call them the bear case and the bull case.
The bear case: The beliefs that AI will gut certain industries and PE is a powder keg of losses become the overriding narratives. Markets predict a deluge of bankruptcies and losses on corporate loans. PE firms’ risks are believed to be systemic. Credit spreads blow out. Banks would pull back warehouse lines. Liquidity vanishes. From there, stress would spill into broader fixed income markets, widening risk premiums and pushing borrowing costs higher.
We are not there. Because the ‘systemic risk’ narrative is the dog that never hunts, this is not our base line scenario. (Do spreads widen from here? Maybe. Does it cause the market to seize up? No).
The bull case: By contrast, the Goldilocks scenario over the next several months looks like this: PE and corporate loan angst lingers, but it does not metastasize into fixed income contagion. The damage remains contained to PE loans. The threat of spillover keeps markets cautious, pushing Treasury yields modestly lower. Lingering PE concern drives another 10 to 25 basis points of decline in long-dated Treasurys — indicative of caution, not panic.
Said another way, as with the tariff tantrum in April, CRE remains largely immune. CRE is looked at as the steady alternative to software stocks. Spreads remain range bound, borrowing costs dip, and CRE economic activity grows.
This is the scenario that makes more sense to us.
Stay tuned.
