Mall Valuations Post GGP/BPY

This is my fifth post on high quality mall REIT valuations in less than a year. Going back to my first post on May 4, 2017 ( https://shulmaven.blogspot.com/2017/05/a-new-look-at-mall-reit-valuations.html) I noted that the 4.5% cap rates used by most REIT analysts were way to low and I argued that a 5.65% cap rate was more appropriate. This analysis did not receive much support when Unibail announced its acquisition of Westfield last fall that implied a cap rate for its U.S. assets in the high 4% range.

However, the Brookfield Property Partners (BPY) acquisition of the 64% of the shares of GGP that it did not own at an implied cap rate estimated to be in 5.8%-6% range validated my thesis. The BPY offer was valued at around $22 per GGP share, 19% below the Street consensus net asset value of $27.28. Warning: take Street estimates of NAV with a grain of salt.

If anything I was too optimistic. I argued then that high quality mall cap rates were under stress because the e-commerce challenge would require significantly high capital expenditures, lower future estimates of rent growth and cause a downgrading of approximately 15% of the those malls considered to be high quality over the next five years.  As of today the first two of my assumptions are now the conventional wisdom. I also argued that higher long term interest rates would pressure cap rates.  Since then the 10 year treasury yield has increased from 2.3% to 2.8%.

Yesterday mall stocks tanked on the GGP news. However, today the mall REIT shares are soaring on reports that President Donald Trump is out to get Amazon, their arch nemesis. As of 3:00 PM EDT AMZN was off by 5% and SPG, for example, was up by 3%. In my view today's stock market action is a transitory phenomena and the mall REITs will be revalued to reflect the GGP transaction. Simply put, AMZN ain't going away, Trump or no Trump.

What that means is that once the Street adjusts net asset values to reflect high quality mall cap rates in the high 5% range, the stocks will settle in to trade at about a 10% discount from the new asset values which implies moderately lower share prices. Why? There is still too much uncertainty in the space and in my view long term interest rates will be significantly higher by year end.

My Amazon Review of Amy Chua's "Political Tribes: Group Instinct and the Fate of Nations"

The Return of Tribalism

Yale law professor Amy “Tiger Mom” Chua has written an important book on the role of tribalism in our modern world. She demonstrates how U.S. foreign policy went awry in Vietnam, Afghanistan, Iraq and Venezuela because how we completely failed to understand the tribal motive behind those conflicts. In particular she highlights the role of economically dominant minorities who breed resentment among the broader population. In particular the Vietnam War was more about deposing the economically dominant Chinese minority rather than a struggle for and against communism.

She then moves on to the U.S. where after years of promoting multi-culturalism it is not surprising to see a broad section of the white community seeing themselves as being victimized by an economically dominant coastal elite. But this is not new to the rise of Donald Trump. In the 1990’s we witnessed New York City Mayor Rudy Giuliani criticizing a Robert Mapplethorpe exhibit at the Brooklyn Museum that depicted Christ in a jar of urine entitled “Piss Christ.”  The exhibit stood, but what if the museum exhibited “Piss Moses” or “Piss Mohamed.” Later “The Book of Mormon,” a satire on the Mormon religion became a hit Broadway show. I doubt if Broadway would have run “The Book of the Koran.”

What I liked about Chua’s book is that she notes that tribalism through years of evolution is built into the human psyche so we shouldn’t be surprised to see it manifested in the United States. A tribe needs to include and a need to exclude. Quite a bit of this, unfortunately, is based on race.  However, for the most part, we rose above tribalism by establishing a “super group” (her words) to rise above it to become Americans. With the return of tribalism the notion of America is pushed into the background.

I also like her noting that the coastal elites have become a tribe of their own as they dominate most of our culture. On the far left the culture has become so strict that the doctrine of intersectionality, which means to be in our tribe you have to be with us on everything to be with us at all. A world where deviation is not tolerated sounds very much like the worlds of Hitler and Stalin in the 1930s. Unfortunately that is where the left is today. To be sure Amy Chua is not as harsh as me, but is clear-eyed on the issue.

All told, Amy Chua has written an important book about where we are in America today. It should be read in conjunction with the works of NYU professor Jonathan Haidt.

For the full Amazon URL see: https://www.amazon.com/review/R73L2N1MYL46U/ref=pe_1098610_137716200_cm_rv_eml_rv0_rv

My Amazon Review of Brad Snyder's "The House of Truth: A Washington Political Salon and the Foundations of American Liberalism"

The Birth of the Administrative State

University of Wisconsin Law School professor Brad Snyder has written a very long book (824 pages in the print edition) on the origins of American liberalism. He tells his story through the collection of people who lived in and/or visited a house located at 1727 19^th Street in the DuPont Circle neighborhood of Washington D.C. between 1912 -1919 and he then follows them through the early 1930’s.  Here we meet such liberal icons Justice Oliver Wendell Holmes, Louis Brandeis, Felix Frankfurter, Herbert Croly, Walter Lippmann (in his early life) and the sculptor Gertzon Borglum (think Mount Rushmore).

All of them were upset with the more conservative strain of the Taft Administration as compared to Teddy Roosevelt’s and all of them want to move  away from the laissez faire philosophy of the 19^th century and to move towards a regulated economy run by disinterested experts. Their attitudes were in response to the emergence of an industrial society that was a far cry from the Jeffersonian vision of a democracy based on yeoman farmers. Simply put they wanted to use Hamiltonian means to achieve liberal ends.

It is all so remarkable to read that the Washington D.C. of those days was a very small town and many of the residents and visitors had ready access to the leading figures of government from the president on down. And boy did they use that access, especially during the Wilson Administration. We see Frankfurter running the War Labor Board, Borglum investigating fraud in aviation procurement and Lippmann writing what was to become Wilson’s Fourteen Points and become part of the U.S. negotiation team at Versailles.

Snyder shows how Brandeis and Frankfurter influenced Holmes to become a leading civil libertarian on the Court as they applaud his pro-regulatory views. The book spends far too much time on the liberal cause celeb of the 1920s, the Sacco-Vanzetti case.  To be sure in a strict legal sense they were victims of a miscarriage of justice but as Snyder tells us in an endnote, modern scholarship suggests that Sacco was guilty. He should have been more honest in noting that upfront.

Snyder also shows us how Frankfurter sent his best students to be law clerks for the Supreme Court. One notable success was Dean Acheson Truman’s Secretary of State who clerked for Brandeis. Two others mentioned did not turn out as well. Tommy “the Cork” Corcoran clerked for Holmes was an architect of the New Deal, but later be became one of Washington’s great “fixers.” Many followed in that tradition by going to Washington to do good and ended up doing well. The other clerk he sent to Holmes was Alger Hiss, the notorious Soviet Spy.

What I liked about the denizens of 1727 19^th Street was that unlike too many of today’s progressives, they really believed in free speech and that Frankfurter and Brandeis were full-throated supporters of the Zionist project. Although Snyder carefully notes Lippmann’s move to the Right, he hardly spends time on how later in life Frankfurter became one of the leading conservatives on the Supreme Court. He stayed true to his belief that courts should give great deference to elected legislatures. Finally Snyder doesn’t deal with the dark side of the administrative state where nameless and faceless bureaucrats, many with heavy political agendas, dictate practically every nook and cranny of American life.

Nevertheless for readers who slog through the book, they will get a real sense of ferment of ideas that made liberalism a major force in our society.

The full amazon URL appears at: https://www.amazon.com/review/R1FN340T5FBJXM/ref=pe_1098610_137716200_cm_rv_eml_rv0_rv

And What did you do in the Trade War?

With his proposed tariffs on $50-$60 billion of Chinese goods, it seems that President Donald Trump wants to start a trade war. As if on cue the S&P 500 dropped 2.5% today and export oriented Boeing and Caterpillar declined by more than 5%. To be sure the U.S. has serious issues with China with respect to trade in general and intellectual property specifically, shooting first and asking questions later is hardly the best way to settle a trade dispute.

As a result investors are rightly worrying about the broad imposition of tariffs on China on inflation and growth. Simply put a tariff is a tax that will increase inflation and slow growth as the Chinese retaliate against American made goods. It is a recipe for stagflation that will hardly be good for stocks.

Of course Trump's announcement could be an opening gambit in a very complex negotiation. That was the case with his steel and aluminum tariffs a month ago. He has since exempted our major trading partners in those commodities namely Canada, Mexico, Brazil and South Korea. Thus it is no surprise that the steel and aluminum stocks have given back all of the gains they made on the initial tariff news. But make no mistake Trump is playing with fire, and a good chunk of the global trading structure could burn down. 

In the Wall Street Journal (online) on Fed Tightening, March 15

David Shulman, senior economist at UCLA Anderson Forecast, said investors are “underestimating the tightening cycle.”

See https://www.wsj.com/articles/wsj-survey-economists-see-steeper-fed-rate-path-stronger-inflation-1521122401  Pay wall

My Amazon Review of Jason Matthews' "The Kremlin's Candidate: A Novel"

Spy Hunters

Former CIA operations officer Jason Matthews has offered up his third and likely final book in his “Red Sparrow” series of novels on Dominika Egorova, a CIA spy operating in the heart of the Kremlin. To get a sense of whom Egorova is I would note that Jennifer Lawrence is playing her in the newly released “Red Sparrow” movie.

Although not quite as good as the first two, “The Kremlin’s Candidate” packs quite a punch. In Moscow Egorova is well on her way to becoming the head of the SVR (Russian Foreign Intelligence Service) wining, dining and bedding Putin all the while the Kremlin is running an agent in the United States destined to become the CIA Director. It is Erogova’s and her CIA handler and lover, Nathaniel Nash, role to foil the Kremlin’s plot. Similarly the Russians are searching for a mole in their security services with Erogova in and out of the cross hairs.

Along the way we visit Khartoum, Hong Kong and yes, Staten Island, New York. We learn much of the tradecraft used by the CIA and the Russians and of how the Russians use “illegals” in the United States. (Shades of the TV series “The Americans”) We also get a very real sense that Matthews doesn’t like the wimpy politicians who ran America’s foreign policy under the Obama Administration. My guess is that he will like the current crop of politicians even less. As with his prior two books Matthews ends each chapter with a recipe for a menu item that was eaten in the chapter. Trust me; there are some real good ones here.

Although the reader doesn’t have to read the earlier novels first, it certainly helps. You won’t be wasting your time. Enjoy.

The full Amazon URL appears at: https://www.amazon.com/review/R8G9GXRKEST4E/ref=pe_1098610_137716200_cm_rv_eml_rv0_rv

"Regime Change," UCLA Anderson Forecast, March 2018

Regime Change

David Shulman

Senior Economist

UCLA Anderson Forecast

March 2018

The sudden 10% decline in stock prices (see Table) and the rise in long-term interest rates in early February signaled what economists call a “regime change.” (See Figures 1 and 2) The economic environment is changing from one of sluggish growth and low inflation to one of accelerating growth and moderate inflation. Moreover, monetary policy is transitioning from one of accommodation to one of normalization and fiscal policy is moving from a moderate deficit to a high deficit regime with trillion dollar deficits in the on deck circle. (See Figure 3) The $300 billion budget compromise (2 years) combined with the recently enacted $1.5 trillion dollar tax cuts (10 years) highlighted the demise of the so called deficit hawks. Included in the budget compromise was a substantial increase in defense spending which ratified our long held belief that the era of contraction in that sector is over. (See Figure 4)

Figure 1. S&P 500 Index , 24Feb17 – 23Feb18

Sources: Standard and Poor’s via BigCharts.com

Figure 2. 10-Year  U.S. Treasury Bond Yields, 24Feb17 – 23Feb18

Sources: BigCharts.com

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                          Will the 2018 Stock Market Be a Rerun of 1987?

                             

The quick run-up in stock prices in January took place under a backdrop very reminiscent of the boom and crash in stock prices that took place in 1987. Recall that the S&P 500 advanced 33% from January-August 1987, only to decline by 39% by October. Further, like 1987 there was a Fed transition from Volcker to Greenspan in August of that year while Powell replaced Yellen in January of this year. However, unlike 1987, stocks dropped 10% in January, while in 1987 a similar drop took place in April. The Table below highlights the similarities and a few differences between 2018 and 1987.

                                                            Similarities

Indicator                                     January 1987                     January 2018

S&P 500                                       +13.2%                               +7.5%*
Extended Bull Market                Started 8/82                     Started 3/09
Computer Trading                      Portfolio Insurance         Algo Trading
Economy                                    Strengthening                      Strengthening
Profit Growth                             Accelerating                         Accelerating
Dollar                                         Weakening                           Weakening
Oil Prices                                    Up from lows                     Up from lows
Inflation Rate                             Increasing                            Increasing
Fed                                             Tightening                             Tightening
10-Year Treasury Yields         Bottoming, about to rise   Rising     
Pro-Growth Tax Reform            1986 Tax Act                     2017 Tax Act
Trade Tensions                           Japan/Germany             China/NAFTA
White House Scandal                Iran/Contra                     Russian Interference

                                                        Differences

Europe                                        Uniting                                   Dividing
Big Power Rivalry                      Declining                               Increasing
Shiller CAPE                               14X                                        35X

*-As of January 26.

Source:  https://shulmaven.blogspot.com/2018/01/eerie-parallels-january-2018-january.html

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Figure 3. Federal Deficit, FY 2010 -FY2020

Sources: Office of Management and Budget and UCLA Anderson Forecast

Figure 4. Real Defense Purchases, 2010 – 2020

Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Growth Driven by Business Investment

Spurred by rising business fixed investment, real GDP growth is on track to continue its 3% pace established in the second quarter of 2017. (See Figure 5) For all of 2018 we forecast a growth rate of 2.9%, but that will slow to 2.6% in 2019 and a sluggish 1.6% in 2020. Why the slowdown? Simply put, the economy is already operating at full employment and it is bound by slow labor force growth and sluggish productivity. Nevertheless, job growth will continue, albeit at a slower clip than in recent years and the unemployment rate will hit 3.5% in early 2019. (See Figures 6 and 7)

Figure 5. Real GDP Growth, 2010Q1 – 20120Q4F

Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 6. Payroll Employment, 2010Q1 -2020Q4F

Sources U.S. Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 7. Unemployment Rate, 2010Q1 – 2020Q4

Sources: U.S. Bureau of Labor Statistics and UCLA Anderson Forecast

As we mentioned above, the key driver of the economy will be business fixed investment. All three categories of business fixed investment (equipment, intellectual property and structures) will be expanding robustly in 2018 with real equipment spending leading the way with a gain of 8.4%. (See Figures 8, 9, and 10) Business investment is responding to pent-up demand, the near moratorium on new regulations by the Trump Administration as well as the reduction in business taxation and the new 100% expensing rules for the depreciation of capital equipment. Nevertheless, growth here will slow as the economy begins to operate at its full potential.

Figure 8. Real Equipment Spending, 2010Q1 -20120Q4F

Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 9. Real Intellectual Property Spending, 2010Q1 – 2020Q4F

Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 10. Real Business Investment in Structures, 2010Q1 -2020Q4F

Sources: U.S. Department of Commerce and UCLA Anderson Forecast

No Boom for Housing

Although housing activity will continue to expand through 2019, it will be far from a boom. Higher interest rates (discussed below) and higher home prices will take their toll on housing starts. (See Figure 11) Simply put, if we didn’t have a housing boom with mortgage rates below 4%, how will we have one when mortgage rates exceed 5%? Thus, after recording 1.2 million housing starts in 2017, we are forecasting 1.3 million units in 2018 and 1.38 million and 1.36 million units in 2019 and 2020, respectively.

Figure 11. Housing Starts, 2010Q1 – 2020Q4

Sources: U.S. bureau of the Census and UCLA Anderson Forecast

A Blow Out in the Trade Deficit

Although President Trump has railed against the trade deficit, the stepped up pace of economic activity along with increase in the federal deficit will cause the trade deficit, as measured by real net exports, to increase from $620 billion in 2017 to nearly $800 billion in 2020. (See Figure 12) Because the United States is consuming more than it is producing it has to make up the difference through imports. As a result, the Trump fiscal policy will be playing a major role in increasing the trade deficit. Moreover, instead of improving the situation, the Trump Administration proposals to increase tariffs on steel and aluminum will actually make things worse as domestic costs rise and foreign producers retaliate.

Figure 12. Real Net Exports, 2010 -2020

Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Higher Wages, Inflation and Interest Rates Ahead

One of the triggers of the stock market sell-off in early February was a reported increase in average hourly earnings of 0.3% in January over December. Instead of using hourly earnings we prefer to use the employee compensation index as a better measure of the strength of the labor market largely because that index includes bonuses and benefits. In 2017 that index increased at a very modest rate of 1.4% over 2016, but the quarterly run rate for 2018 will likely be above 4% and approach 4.5% by 2020. (See Figure 13) This is how a fully employed economy is supposed to behave.

Figure 13. Employee Compensation per Hour, 2010Q1 – 2020Q4F

Sources: Bureau of Labor Statistics and UCLA Anderson Forecast

Inflation is not as quiescent as it was earlier in the decade. The fears of deflation have abated and for the first time since 2012, the consumer price index increased by over 2%. Going forward, with the end of the oil price rout and rising wages coming from an increasingly tight labor market, inflation as measured by both the headline and core consumer price indices will exceed 2% over the forecast horizon and likely reach 3% in 2020. (See Figure 14) Indeed, the month-over-month increases reported for January in the headline and core consumer price indices of 0.5% and 0.3%, respectively, is supportive of our view. Moreover, the price cuts for cellular services will anniversary this spring and that will trigger a near automatic increase in year-over-year inflation.

Figure 14. Headline vs. Core Consumer Price Index, 2010Q1 -2020Q,

Sources: U.S. Bureau of Labor Statistics and UCLA Anderson Forecast

In a fully employed economy, with rising inflation and an exploding federal deficit, what is a central bank supposed to do? The answer is obvious. The Fed will become more aggressive in raising interest rates. We are forecasting four quarter point hikes in the federal funds rate this year and continued increases throughout the forecast horizon to a target of 3.25% - 3.5% in 2020. (See Figure 15) We are aware that this looks very aggressive, but we would surmise that former Fed Chair Janet Yellen would be on board with this. Why? She, as an adherent of the Phillips Curve, would be troubled by our and other forecasts of a 3.5% unemployment rate which would signal oncoming inflation and as a neo-Keynesian economist she would be horrified at trillion dollar federal deficits being overlaid on a fully employed economy. We would expect no less from Jay Powell, the new Fed chair.

Given the prospect of rising inflation and a substantial increase in Treasury issuance arising from the deficit, long-term interest rates will likely surprise on the upside. Further, with the Fed shrinking its balance sheet, which in effect works as a net issuance of government securities, the long shortage of “safe assets” is about to come to an end with a vengeance. Further, with both Europe and Japan now firmly in recovery modes, their periods of unusually low interest rates are also about to come to an end. Thus, we would not be surprised to see the 10-Year Treasury yields exceeding 3.5% this year and cross 4% in 2019.

Figure 15. Federal Funds vs.10-Year U.S. Treasury Yields, 2010Q1 -2020Q4

Sources: Federal Reserve Board and UCLA Anderson Forecast

Conclusion

The title for the report is “Regime Change.” We mean it. The Trump Administration has put in place an all-out stimulus policy on top of a fully employed economy. As with an automobile, when an economy runs hot, sometimes a few gaskets break. Near-term, spurred by strong business fixed investment, the outlook is for continued 3% growth, but as we enter 2019 the economy could very well begin to sputter under the strains of higher inflation and interest rates and by 2020 it could very well stall out.

Will Trump Tariffs Force Gary Cohn Out?

As I write this stocks are in free fall after President Trump announced that he will impose a 25% tariff on steel and a 10% tariff on aluminum. It signals the opening salvo in a trade war that will raise prices domestically, harm export industries and weaken alliances abroad.

However the knock-on effect could trigger the resignation of National Economic Council Director, Gary Cohn. Cohn clearly lost a very public internal fight against the protectionist wing in the White House, namely Peter Navarro, Wilbur Ross and Robert Lighthizer. Because the financial markets have been reassured by the presence of Cohn, a former Goldman Sachs executive, his leaving of the White House would trigger further selling. Given the wholesale resignations from the Trump White House, why should Cohn's leaving be any different.