The Deflationary Economy

The Real Estate Espresso Podcast

The Deflationary Economy

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Welcome to the Real Estate Espresso Podcast, your morning shot of what’s new in the world of real estate investing. I’m your host, Victor Menasce.

Today, we’re talking about the deflationary impact of an oil shock. Now, that might sound counterintuitive at first. After all, if oil prices spike and shortages appear in oil or aluminum, fertilizer, natural gas, any number of other commodities, most people’s instinct is to call that inflationary. And at the consumer level, it feels inflationary. You see it at the pump, you see it in groceries, you might even see it in utility bills. You certainly see it in transportation and maybe construction costs.

But that’s only the first-order effect. The deeper question is, what does a commodity shock do to the broader economy? History gives us a consistent answer. Oil shocks are not expansionary, they’re contractionary. They’re not a fuel for growth; they’re like a tax that crushes growth.

In the 1970s, we called it stagflation. It was supposed to be impossible according to economic theory at the time. When the price of energy rises suddenly, households and businesses do not magically become wealthier, they become poorer. More of their income gets diverted towards necessities, and less is available for discretionary spending, for investment, for hiring, and for growth. That’s not a recipe for sustainable growth; that’s a recipe for demand destruction.

Energy sits at the base of the entire economic pyramid, and for every unit of economic output, there’s an equivalent unit of energy consumed somewhere in the world. Energy is embedded in transportation, in agriculture, mining, manufacturing. It’s in everything. Natural gas is critical for power generation, for heating, and fertilizer production. Aluminum production is electricity-intensive. Fertilizer is essential to producing food. All of these are under pressure at the same time.

You’re not looking at a healthy economy with too much demand. You’re looking at an economy that’s being starved of inputs. And when an economy is starved of inputs, output falls. There’s no other conclusion.

We might see interest rates rise because the urban legend says that when prices rise, so must interest rates, and this is where I believe central bankers can get the diagnosis wrong. If they only look at headline inflation, they might conclude that the prescription is higher interest rates. But if inflation is being caused by a supply shock, especially an energy shock, then raising rates does not produce more oil. It doesn’t unblock a shipping lane, it doesn’t create more fertilizer, and it doesn’t produce more natural gas. It doesn’t mine more bauxite for aluminum.

What it does do is destroy more demand. It’s an additional tax on demand that further suppresses demand. The so-called cure of raising interest rates compounds the disease instead of fixing it. In other words, it piles a credit contraction on top of the physical shortage.

So that’s why standard central bank playbooks could be misguided at a moment like this. They treat the symptom as if it was the disease. The symptom is rising prices; the disease is impaired supply, and these are very different.

If the Persian Gulf is blocked, and if oil tankers that departed before the start of the conflict have not yet reached their destinations, then the full effect of the shortage might not even have arrived yet. There’s always a lag between the event and the physical manifestation in local markets. Currents are floating inventory. Pipelines and storage facilities create buffers. They’re not very long, it’s only usually a matter of a month or two at the most. But once those buffers are exhausted, the shortages become visible very quickly.

We’re seeing it in Australia, we’re seeing it in the Philippines, we’re seeing it in India. The reaction to the shortage happens in stages. First, prices rise. Second, margins get squeezed. Third, demand starts to collapse in discretionary sectors. And then fourth, you start to see depreciation and layoffs. And then finally, asset prices reprice downward because the economy is no longer capable of supporting the prior valuations.

That sequence is deflationary, even if the initial spark looked inflationary. And for real estate investors, that distinction matters a lot. If you misread an oil shock as a normal inflation event, you might assume that hard assets will simply rise in value across the board, but that’s not how it works.

Real estate is not immune to a shrinking economy. In a supply-driven inflation shock, cap rates can rise because risk is rising. Debt becomes less available. Construction costs can go up. Rents will not keep pace because tenants are under financial stress. Households faced with high fuel and food bills have less money to spend on rent. Businesses paying more for logistics and utilities have less capacity to absorb vacancy. Industrial users could cut production. Retailers would see lower traffic. Business tenants may shrink footprints. Hotels will experience lower travel.

That is not a growth proposition. That is margin compression across the entire economy. The projects that survive in that environment are the ones that are conservatively underwritten with lower leverage and solving a real need in a strong sub-market. This is not a time for speculation, and this is not a time to assume that inflation will bail out a weak business plan.

We’ve seen this movie before, and you need to separate price inflation from monetary inflation, and both of those from economic growth. It’s not the same thing. A true energy shortage functions like a brake on the economy. It takes income away from discretionary uses and channels it into keeping the lights on.

So what should you do? First of all, preserve liquidity. Second, stress test every assumption. Third, you want to assume that higher input costs and weaker demand can happen at the same time. You want to favor projects with clear affordability advantage or some mission-critical use. And then finally, you want to remember the best opportunities often come after repricing, not before it.

An oil shock is not just about expensive gasoline. It’s about impaired industrial output. It’s about weaker consumer demand, lower output, and eventually economic contraction. The immediate price inflation is visible, but the deflationary consequence takes a little longer to recognize, but it’s there all the time.

As you think about that, have an awesome rest of your day. Go make some great things happen. We’ll talk to you again tomorrow.

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