All the major financial newspapers from the Wall Street Journal to The Financial Times are sounding the alarm bell on economic contraction at the moment. On today’s show we’re going to take a deeper look at what the numbers are telling us and see what it means for us as real estate investors.
Economic cycles are the result of expansion of supply capacity and building of inventory ahead of demand. That’s the general cause. These types of cycles happen in everything from semiconductors to automotive to housing. Suppliers expand their capacity and output in response to rising demand during an economic boom. All the suppliers do this at once hoping to gain market share during the expansion. But once that demand gets satisfied, there is excess capacity in the market and often excess inventory. But it takes a while for the suppliers to notice the excess supply. By the time they notice, it’s usually a problem. Inventories have grown to unsafe levels and businesses slam on the brakes to protect the very survival of the business.
The latest news out of Europe is that Germany’s economy contracted by 0.1% in the second quarter and narrowly missed a contraction in the first quarter. Germany is the largest economy in Europe and is responsible for nearly 50% of the exports of all of Europe. There are 27 other countries and then there’s Germany. While this contraction isn’t huge. It’s barely a contraction at all, much of Germany’s output is export based, particularly in the automotive business. If we focus on manufacturing, Germany’s industrial output dropped 1.5 percent in June and is now down 5.2 percent year-on-year. This is a big shift.
Investors hate uncertainty. At the moment we’ve got plenty. The outcome of the trade negotiations between China and the US is far from known. We have the possibility of a no-deal Brexit less than 90 days away. The implications of a no-deal Brexit on the economies of the UK and the rest of Europe are hard to determine.
Europe’s economy is highly dependent on exports. A global trade war could have a major impact on the European economy. Europe has twice the population of the USA and it’s economy is of a similar size to the US.
I know that very little of what is happening in the trade dispute is affecting my business directly. The only significant impact has been on the price of steel which has jumped 25% in the past year. But structural steel only makes up a small fraction of our construction costs. The net result is an increase in prices of less than 1% on our overall project costs. This is happening at a time when the market overall has seen strong rent growth, averaging 5.1% in the past year as reported recently by Freddie Mac.
The bigger question is what will happen in the broader economy. Will we start to see businesses contracting their investments? Will we start to see workforce reductions like we have seen in past economic downturns? For the moment, we continue to see what might be a soft landing. We are not seeing the kind of overheated market conditions in 2007 with bloated inventories across the board.
In select real estate markets like the SF Bay Area and San Diego we are now seeing a slowdown in foreign investment, and a slowdown in construction activity.
As real estate investors we need to pay attention to what’s happening in your local market in order to make sound investment decisions. From the news this week, we’re not making any changes and holding to our plans.