Geopolitical risk has been overstated and most geopolitical risk is already priced into investments, according to American historian, academic and author Professor Stephen Kotkin. And while some geopolitical risk is un-priceable, such as war, “if you can avoid a war between major powers, you can manage geopolitical risk,” Kotkin said.

Speaking via video link at the Fiduciary Investors Symposium hosted in Sydney, Australia, by Top1000funds.com sister publication Investment Magazine, Kotkin said cold war is not such a bad outcome, and may even be sustainable.

“Cold war, or managing a relationship where there are tremendous differences and you avoid a hot war, is a really good outcome, and that’s where we are right now,” Kotkin said. “And if we stay this way, we’ll be fine.”

Moving first to Ukraine, Kotkin said even if Ukraine’s counter-offensive is highly successful, “winning the peace is a lot harder than winning the war”.

“They are related but one doesn’t follow from the other,” he said, noting the US had failed to win the peace in both Iraq and Afghanistan.

Winning the peace in Ukraine would require accelerated European Union accession for Ukraine, and “some type of security guarantee, not likely NATO at this point”, Kotkin said, but that could look like the US agreement with South Korea – “an armistice that’s not dependent on territory,” which may involve Ukraine not getting back all of its internationally recognised territory.

Kotkin, a senior fellow at Stanford University’s Freeman Spogli Institute for International Studies, said the war is a tragedy but is also an opportunity for the West to re-discover the values on which it is based, to rediscover the importance of relationships, and to discover “that it had not been paying attention to large parts of the world” – which has caused to apathy from a range of countries towards issues of concern to the West. 

Potential futures for Russia

Kotkin ran through a range of futures for Russia. One possibility, albeit an unlikely one, is that Russia ceases to be a threat to its neighbours and becomes institutionally part of the West. An authoritarian leader – “a nasty person potentially” – could recognise the separate existence of Ukraine and cease hostilities. Russia could become a Chinese puppet regime, with outcomes for Ukraine that are hard to predict.

Russia could also continue on the path it is on now towards being a “very, very large North Korea,” persecuting its own people, threatening its neighbours, isolated from the international order with “nothing to lose by causing trouble.” Russia could also go through “chaos, possible semi-disintegration” with troubling repercussions for the region and the globe given Russia’s capabilities. The country could also undergo some other “black swan” even nobody can predict.

While some people in Washington have been hoping to “break Russia off from China in order to contain China”, the real game should be “engaging with the Chinese to help us manage the problem of Russia”, and stave off some of the worst possible scenarios, Kotkin said.

The Ukraine invasion has revealed a lot of lessons relevant to China, Kotkin said. “The West is not in decline, is not decadent, is not going away and is, on the contrary, unified, powerful, resilient and large – very large and substantial,” he said.

The West also has technology China relies on and has consolidated alliances around the world. The greatest protagonist on behalf of the West is Xi Jinping, Kotkin said, as “without him, we wouldn’t have this kind of consolidation”.

And Ukraine demonstrates that “if you militarily try to take a country like Ukraine or a self-governing island like Taiwan, you cannot have it”.

“You get a smoking pile of rubble, Kotkin said, and a Chinese invasion of Taiwan “would be an act of total desperation on their part”. Continuation of the status quo is the best option for all involved, he said.

But the biggest threat to global order is not China. Rather, it is “American fiscal insanity and the fiscal insanity of many of our friends and partners”, Kotkin said. Whether the West manages to get its house in order remains a big variable.

Every generation throughout history believes it has lived in innovative times, and yet, every generation brings its own innovation and change. The reality is that defining what innovation looks like can be quite hard.  Steve Jobs described it as “putting a ding in the universe”; Thomas Edison as “finding a better way to do things”; and science fiction writer, Arthur C Clarke as “going beyond the limits of the possible”.

For the asset management industry, innovation has been driven by the proliferation of data; advances in technology, including the widespread adoption of artificial intelligence (AI); and commitments to ambitious sustainability goals – all of which have caused significant disruption to the business, people and investment models of organisations.

Economist and Santa Fe Institute external professor, W. Brian Arthur, maps this digital and data revolution over the last 50 years – from integrated circuits, processors and memory chips in the 1970s/80s; to the connection of digital processes and computers via the internet; to the development of magnetic, gyroscopic, radar and other sensors. The latter is critical as these sensors brought us oceans of data and it is estimated that the asset management industry has nearly tripled its spending on data since 2017.  The challenge for our industry today is how to make sense of it all, while providing benefits for its stakeholders, with the use of artificial intelligence playing a leading role.

Benefits can’t be understated

The benefits of artificial intelligence to our industry cannot be understated and we see investors trying to harness its power through the use of natural language processing, image recognition and machine learning.

From processing unstructured ESG data from alternative sources with the aim of assessing company risk; to using AI in private markets to source deals and conduct due diligence on businesses; to improved customisation of products and client experiences. We also see its benefits in improved trade-execution algorithms; searches for new sources of alpha through alternative data and the generation of synthetic data points and scenarios; and reduced costs for data management.

Indeed, around 63 per cent of banks and investment firms surveyed confirmed that they are currently deploying or already using AI, with a further 28% intending to deploy it over the next 1-3 years (Gartner Data and Analytics Transformation Survey, 2022).

However, it is the development of generative AI – where machine learning models are trained to generate new content and data by training on existing data sets – that has caused divisions: the optimists who see the significant opportunities to drive work efficiency, allowing our workforce to do different, higher-value tasks (the National Bureau of Economic Research (NBER) recent working paper, Generative AI at Work, which points to a 14 per cent productivity improvement, with the greatest impact on novice and low-skilled workers); the pessimists who emphasise AI’s potential to propagate misinformation and create widespread disruption to jobs or even existential risk to human life; and those in-between who see lots of opportunities for AI’s use but strongly highlight the need to mitigate and manage its risks.

Social technology generally lags behind the development of physical technology and, as such, we need to be aware of the risks and put in place guardrails, while embracing its benefits.

We also need to not underplay the roles of human intelligence (HI) as a complement to rapid advances in AI use cases. Indeed, the combination of AI + HI will be especially powerful if we are to learn the intrinsic limitations of this technology and adjust our part in this combination.

Empathy, judgement and the ability to inspire

The reality is that AI cannot yet fully replicate human behaviour in all its dimensions. Traits such as creativity, empathy judgement and the ability to inspire others are very much the reserves of humans. We are also reminded that the skills of the future (The investment professional of the future, CFA Institute, 2019) are not just technical, but also include soft skills such as relationship and building social capital; leadership skills such as crisis management and instilling an ethical culture; and T-shaped skills including situational fluency and adaptability. And we also need judgement and inference skills to consider data in its full context where simple causality is not present in a complex system and where trade-offs need to be made between highly objective/valid hard data and softer more subjective data that may be more material.

Data science and analytics have become a vital part of the investment business. But the ultimate test of quality in data and technology will be related to the quality of decision-useful information and the connected insights, judgements, processes and algorithms applied to it.

AI can indeed be a game changer for our industry – it is a systemic opportunity – but only if we are able to mitigate the risks that have and will come from multiple sources. It is the powerful combination of AI + HI that will truly deliver long-term value – enabling us to make better decisions quickly and more consistently, with the human touch.

Marisa Hall is head of the Thinking Ahead Institute at WTW, an innovation network of asset owners and asset managers committed to mobilising capital for a sustainable future. 

Bank runs bought down three regional lenders in the US earlier this year and the sector is poised for more consolidation ahead, warns Steven Meier, CIO and Deputy Comptroller for Asset Management at $233.5 billion New York City Retirement Systems (NYCRS).

Ever since the failure of Silicon Valley Bank, Signature Bank and First Republic, a growing number of other regional lenders are facing mounting risk from falling deposit rates and costly regulation. They are also unlikely and unwilling to make new loans, with profound implications for businesses.

A key reason behind mounting risk at regional US banks is the growing divergence between the Fed funds rate and interest rates on checking accounts, increasing the risk of bank deposit outflows. As interest rates track higher, saving account holders are moving their deposits out of banks to higher yielding T-bills.

“Any individual with money sitting in a checking account can move it to T-bills or a money market mutual fund for a 500-basis point pick up in yield. It is challenging for these banks as these deposits flow out,” said Meier speaking in a recent investment committee meeting.

“These banks are at risk of increased regulatory costs and increased deposit costs which equate to a lower net interest margin and lower profitability on the part of regional banks,” continued Meier. He highlighted the probability of around 30-odd banks including names like Western Alliance, Zion and First Horizon as likely candidates to “reorganize their balance sheets.”

Alongside questioning the ability of struggling regional banks’ ability to make money in the longer term, Meier flagged that the US economy is still “overbanked” indicative that further consolidation is coming down the line. In 1997 the US had around 13,000 banks compared to around 4000 today. “This is still high compared to global standards.”

Recession risk

Along with the likelihood of more regional bank failures, Meier warned that the US economy remains at risk of recession. Although the slope of the US yield curve has been inverted since 2022 and the economy still hasn’t dipped into recession, the warning signs that have predicted every downturn since 1969 continue to flash red.

“The 10-year treasury yield should trade at a premium, but two-year yields are above 10-year yields and this tells us that the market is pricing in a recession at some point in the future.”

Monetary policy acts with a long and variable lag, he warned. The most aggressive rate hiking in 40 years has tightened financial conditions that are still not fully felt through the economy.

He warned that the prospect of recession and tightening credit conditions will cause spreads to widen further .“We will see this in the coming months,” he said, adding that if the economy moves closer to recession, the number of defaults will spike.

Inflation in the US is still strong, primarily supported by resilient consumer spending and China reopening. And the signs that it will remain strong abound. Geopolitical trends around re-shoring, inflationary pressure in the transition and shortfalls in the labour market (although he noted signs that the US job market is slowing) all point to enduring inflation.

Positively, the board heard that for many investors cash is currently “a free lunch” that is both low risk and offers a high return. As such it is a meaningful contributor to active risk.

Factors to watch

Meier warned that in the aftermath of resolved US debt ceiling negotiations, trillions of treasury issuance will put pressure on bill rates, repo rates and other allocations. and said that although equity markets have had a healthy spate of late, the strong dollar is impacting returns on non-US equities. Private markets have seen excess returns at NYCERS although non-core real estate has underperformed.

He warned that public equity returns (NYCERS has around $21 billion invested in US equity) remain driven by a handful of big tech stocks including Apple, Meta, Microsoft and Tesla. This also means that NCYERS’ allocation to large cap stocks has outperformed small caps. “Apple’s market cap exceeds that of the entire Russell 2000 index – it’s quite remarkable.”

NYCERS portfolio has a low active risk level, and most of the fund’s performance comes from the market.

Following an amendment to New York state’s so-called basket clause legislation, NYCERS can increase its allocations to private markets to 35 per cent of assets under management, up 10 per cent. A scheduled review of its large and complex asset allocation across the five different plans with trustees and consultants will set new allocations.

 

Defined benefit schemes in the United Kingdom have put aside much larger collateral buffers since the LDI crisis last year with implications for how they invest. Pension funds typically stress tested their portfolios around a 3 per cent increase in gilt yields, but after last year’s gilt crisis, many funds now scenario-plan for an 8 per cent increase in yields.

“Since the gilt crisis last year, my role has focused particularly on making pension fund portfolios more resilient,” says Tegs Harding, professional trustee with Independent Governance Group.

“DB funds have put in place more prudent collateral buffers than what they had during the crisis. We haven’t been sat on our hands. We’ve got much better collateral defaults in place and we can deal with yield increases.”

Harding is chair of the investment committee at £20 billion ($25.3 billion) Legal & General DC Mastertrust and also looks after a book of seven other pension schemes including the £5 billion Diageo Pension Scheme, where she is also chair. The Mastertrust provides pensions for  around 200 employers from around the UK and has around 1.9 million members.

The large yield increases in gilts last year had a huge impact on DB and DC funds in the UK. DB funds with large LDI exposure and an illiquid book had large and rapid calls for capital and needed to implement contingency plans quickly. To shore up collateral, they divested some assets and organized loans from sponsors to ensure they could maintain their hedge.

Investment strategies revisited

Harding says her role includes working with pension funds to revisit their investment strategies.

“Some DB schemes with, say, a 15 per cent allocation to illiquid investments going into the crisis, will now find themselves with a much bigger allocation (up to 30-40 per cent) to alternatives because of changes in the valuations in their portfolio,” she says.

“We work with them on how to change this.”

UK DC funds have larger collateral pools in place and are much better able to deal with yield increases that DB funds, says Harding.

However, DC funds are still navigating the impact of last year’s correlation between equities and bonds.

“On the DC side, we are focused on making sure funds have invested enough in illiquid assets,” Harding says.

“Investing in alternatives through the growth stage of a DC fund leads to better member outcomes. We look closely at Australia’s DC model where assets are made to work harder with more investment in illiquids and the local economy,” she says.

Harding says governance is getting more complex as regulation comes thick and fast, with trustees required to respond to it.

“Much of a trustee’s job is around policy setting and setting the overall ambition and objectives of a pension fund. And geopolitical risk is increasingly impacting the investment climate,” she says.

“My role is to help pension funds deal with these challenges and keep up with the big systematic risks that need managing.”

Integrating biodiversity

A growing element of her role involves working with pension funds on how to integrate biodiversity. She notes many pension funds began to integrate ESG with a focus on climate and TCFD reporting, but this is evolving. “Now there is a realisation that we can’t just focus on climate in the transition,” she says.

“Many companies won’t do well if we don’t tackle biodiversity too, and we must look at things holistically.”

She notes that diversity amongst UK trustees is increasing because the older generation of trustees is retiring and new, younger people are stepping in.

“Professional trustees are more diversified than member-nominated trustees,” she says. “Pension funds take diversity seriously and want trustees from different backgrounds.”

“My primary role is to make sure that people get the benefits they are entitled to. I provide support on how to invest the assets and value the liabilities; check they are administered correctly and make sure employers are contributing the right amount. We also advise on investment and cyber and operational risk.”

 

Key Takeaways

  • The commercial real estate market faces significant headwinds such as tighter credit conditions, income pressure and elevated refinancing needs over the next two years.
  • In the US, while the risks are acute for owners of office properties, commercial real estate remains a diverse asset class and pockets of resilience can be found.
  • As investors seek to protect portfolios and capitalize on opportunities, it will be vital to monitor multiple near-term risks and potential global economic spillover effects.

Commercial real estate (CRE), the third-largest asset class after fixed income and equities, is under pressure. An aggressive rate tightening cycle by the US Federal Reserve (Fed) and other major central banks over the past year has fuelled concerns about the potential impact on the sector, given its reliance on debt and bank financing. This has been compounded by the prospect of further tightening in credit conditions resulting from recent stress among US regional banks, which are a key source of lending to owners.

The office market faces the greatest headwinds, underscored by several high profile CRE loan defaults hitting the headlines.1 Owners of office buildings are contending with structural challenges led by fundamental changes in the way we work since the pandemic. With more people working from home or on hybrid schedules, many companies are reducing their office space. In the US, this shift has contributed to a steady rise in office vacancy rates, particularly in central business districts. Owners of older buildings that lack amenities and sustainability credentials are finding it even harder to attract tenants.

Outside of office properties, however, the outlook for CRE is less downbeat. Industrial properties such as warehouses and logistics facilities have posted the strongest rent increases in the sector in recent years, though net operating income (NOI) growth may slow along with the economy. We believe that pockets of resilience can still be found in CRE despite the current challenges facing the sector, thanks in part to its diversity. In this article, we review the headwinds facing the US CRE market, examine where opportunities may be found and discuss key factors to consider when making investment decisions.

Stress is Building

 

The pressure on CRE has been created by a convergence of factors, including a sharp increase in interest rates, rising costs and reduced operating margins, income pressure, tighter financing needs and a wall of debt maturing over the next 18 months. These headwinds have put downward pressure on asset valuations and while the performance across CRE sectors is uneven, the oversupplied office market is presenting the most acute challenges.

Rate Sensitivity

The US CRE sector has become increasingly reliant in recent years on floating-rate debt, which has become more expensive following benchmark interest rate hikes by central banks. By contrast, the residential real estate market is comprised mostly of 30-year fixed-rate mortgages. Lenders often require floating-rate loans to be paired with interest rate caps tied to a benchmark such as the Secured Overnight Financing Rate (SOFR), although this still exposes borrowers to rate increases up to the strike rate. While most of these floating-rate loans are hedged to protect against rising rates, the duration of rate caps is generally shorter than the fully extended mortgage term. These hedges therefore need to be reset in order to exercise extension options, exposing borrowers to large capital outlays to reset the hedge, or the need to seek out refinancing in the current constrained environment.

The Share of Floating-Rate Loans in CMBS Portfolios has Risen in Recent Years.

Refinancing Needs

The imminent refinancing needs of CRE owners are another source of stress in the sector, with nearly $1.1 trillion worth of commercial mortgage loans expected to mature before the end of 2024, according to Goldman Sachs Global Investment Research. Given the balloon maturities common in commercial mortgages, many borrowers will have to refinance their existing loans at higher rates—assuming there is no dovish pivot by the Fed during this period.

Refinancing Needs

The imminent refinancing needs of CRE owners are another source of stress in the sector, with nearly $1.1 trillion worth of commercial mortgage loans expected to mature before the end of 2024, according to Goldman Sachs Global Investment Research. Given the balloon maturities common in commercial mortgages, many borrowers will have to refinance their existing loans at higher rates—assuming there is no dovish pivot by the Fed during this period.

Refinancing Needs are Elevated Over the Next Two Years

Tighter Credit

Deposits at small US banks—the dominant lenders to CRE—have decreased by nearly $250 billion since January 2023. This pressure will likely lead to a pullback in lending among some banks, including to the CRE market, reinforcing existing headwinds on the sector. Outside of banks, the securitization market has also slowed, with new issuance of commercial mortgage-backed securities (CMBS) falling sharply. The supply of conduit CMBS is down by 72% in the year to date compared with the same period in 2022. Single-asset/single-borrower CMBS have fallen by 85% and CRE collateralized loan obligations are down by 92%.2

Income Pressure

Downward pressure on net operating income (NOI) from declining rent growth, higher labor and materials costs and, in some sectors, rising vacancy rates, is a fourth source of stress for CRE. These issues are particularly acute in the office sector, while some other property types, such as industrial, are driven by more favorable fundamental dynamics. Overall, CRE borrowers have become exposed to a higher risk of a payment2 shock on their liabilities than households and non-financial corporations. The office sector faces uncertain long-term demand due to the continued popularity of remote and hybrid work among employees. US office utilization is down by 51% nationwide compared with the pre-pandemic period. Further, tenant demand has shifted toward newer buildings with better amenities and sustainability features. More than two-thirds of US offices were built before 1990 and the required repurposing and capital expenditure will weigh on NOI, at least in the near term.

The Decline in Occupancy Rates Has Been More Pronounced for Office Versus Other Types of Properties

Sources of Resilience

 

Credit Quality

Stringent lending standards over the past two decades suggest that the credit quality of CRE loans today is stronger than in the period preceding the savings and loan crisis of the 1980s and 1990s, and the global financial crisis of 2007-2008. Many loans that will mature in the next few years were originated at loan-to-value levels of 50% to 65%.3 This significant equity cushion suggests that the impact of lower valuations will be mostly felt by equity sponsors rather than holders of CRE debt including banks, insurers and investors in CMBS. CRE is highly diverse, comprising everything from offices in major cities to data centers and industrial warehouses in rural areas. The office sector faces headwinds, as discussed above, but it accounts for less than a third of all CRE. Elsewhere, the fundamentals are more encouraging. Rents for multifamily properties have come down, for example, but significant growth in the NOI of apartment buildings over the past two years has raised the bar for defaults. Industrial properties including warehouses and logistics facilities have seen strong rent growth in recent years, though the sector is cyclical so NOI growth may slow along with the economy.

Brick-and-mortar retail stores have been suffering for years from the rise of e-commerce, which accounted for 14.7% of total US retail sales in the fourth quarter of 2022, down from the peak reached in the early stages of the pandemic, but still a significant increase from the level of 5.4% in the same period a decade earlier.4 The default cycle has largely materialized, however, particularly for regional shopping malls. The lodging industry was hard hit by lockdown measures during the pandemic, and although business-oriented hotels have yet to fully recover, tourism-oriented hotels have benefited from a steady recovery in demand.

Overall, the fundamental strength of credit quality in CRE has kept delinquency rates in check. Given the sharp rise in interest rates over the past year and slowing economic growth, we expect delinquencies to trend higher from current low levels, but we believe the rise to remain largely concentrated in the office sector, while other sectors remain relatively resilient.

Loss Rates

The experience of the past two decades suggests that losses on CRE loans tend to materialize over a multi-year period, allowing investors to adapt and lowering the prospect of widespread defaults in the near term. Even after a recession, loss rates only tend to pick up after five to seven years. This lag is the result of several factors. First, the process between a default—when a borrower stops repaying debt—and the liquidation of collateral tends to be lengthy. Second, borrowers and lenders are incentivized to amend and extend loans, postponing the potential realization of losses. Finally, loan maturities and property leases are both spread out over several years. As a result, we believe the prospect of a large percentage of leases being rolled over (or not renewed) and loans maturing (or refinanced at higher rates) at the same time is limited. In the office sector, for example, multi-year leases are commonplace and firms cannot typically terminate leases early just because more of their staff are working remotely. Even if CRE defaults reach the scale seen during the global financial crisis—which is not our base-case expectation—we believe US regional banks and the broader financial sector should be able to absorb the losses provided the US economy holds steady. According to our bottom-up analysis, the total losses for US banks should amount to less than 10% of current Tier 1 capital and accumulate over four years.

The Losses for Banks are Expected to be Manageable Provided the US Economy Holds Steady

Investment Opportunities

 

Private Credit

For private credit investors, the roughly $1.1 trillion of CRE loans due to mature before the end of 2024 creates immediate capital deployment opportunities. While demand for debt is growing, increased volatility and uncertainty have significantly reduced the supply of available credit from traditional lenders and public financing providers. As public markets have pulled back, the resulting supply-demand shift has created an opportunity for private lenders to negotiate higher pricing and more favorable structural protections with borrowers, as well as finance higher-quality assets that would have previously been capitalized by the public markets. Funding gaps between current levels of debt and what lenders are willing to refinance may also drive opportunities in structured financing as owners look for options to retain upside in performing assets.

Securitized Credit

CMBS typically consist of a pool of fixed-rate loans with terms of 5-10 years that are securitized and sold in the secondary market. The market in private-label CMBS stood at $729 billion outstanding at the end of 2022, and conduit CMBS made up about half of that total.5 Single-asset, single-borrower (SASB) conduit loans provide another opportunity for CRE exposure. These consist of a single large loan for a single property that is securitized and sold in the secondary market. SASB CMBS accounted for a third of the market at end-2022, with the remainder in collateralized loan obligations (CLOs). The office sector accounted for 28% of conduit CMBS, 24% of SASB CMBS and 15% of CRE CLOs. The underlying loans in CRE CLOs tend to have a floating rate and are typically linked to “transitional properties” such as multi-family assets under redevelopment/ re-tenanting to stabilize the asset. These assets tend to entail more active management, because loans can be added or removed during a specific reinvestment period, and CRE CLO managers tend to have more familiarity with underlying properties.

We expect many CRE borrowers to extend and modify existing loans to avoid stress. We are also reassured by improved credit quality in the CMBS asset class since the global financial crisis thanks to tighter underwriting standards, a tougher regulatory environment that introduced risk retention rules for CMBS issuers and affiliated parties, lower loan-to-value ratios, and higher interest coverage ratios. We are nevertheless alert to the ongoing pressure on NOI that could diminish borrowers’ willingness and ability to refinance or extend loans, particularly in stressed segments of the CRE market such as low-to mid-tier offices and brick-and-mortar retail properties. As a result, we favor risk in senior parts of the capital structure and exposure to high-quality property types. We expect CMBS transaction volumes to remain subdued overall and we anticipate some pockets of stress, but we think better credit standards since the global financial crisis combined with loan modification options will help to contain spillovers to the broader market beyond the structurally challenged office sector.

Corporate Credit

Banks are among the largest holders of US CRE debt, and investors have understandably grown mindful of potential losses on CRE loan exposure, particularly for the regional banks. Historically, banks have not disclosed property type exposure within their CRE loan portfolio, but in response to investor concerns, many provided more detail in Q1 2023 earnings reports. While certain regional banks may be exposed to losses on CRE loans (particularly in the office sector), we think the risk of widespread losses is curbed by relatively healthier fundamentals in other CRE property types and strong capital positions among larger banks. Further, we are reassured by the fact that all banks have access to Fed funding facilities, usage of which has recently moderated.

Banks Own Over Half of the CRE Loans Outstanding

Looking ahead, while we are alert to the risk of renewed banking sector stress, we also believe extraordinary policy interventions could limit contagion risk. That said, alongside the effects of a slowing economy we are closely monitoring the impact on bank profitability from rising deposit rates.6 During the last US hiking cycle, the increase in deposit rates relative to the rise in policy rates—also known as the deposit beta—was modest. Today, deposit rates remain low but are increasing at a faster pace than they did in the last cycle. This likely reflects the speed and scale of the hiking cycle which has made short-term money instruments and other interest-bearing assets more attractive relative to deposits. The ease with which deposits can move around at the tap of a smartphone app has also likely contributed to the stiffer competition faced by banks for deposits. Overall, a larger-than-expected increase in deposit betas could weigh on bank profitability, as higher deposit rates erode the margin between interest expenses and interest income, making this a key dynamic to monitor to assess the outlook for the sector.


Real Estate Investment Trusts

Market dislocation has increased dispersion of returns across property types, with public REITs trading at historic discounts to private market valuations. While the full effects of the US banking stress on real estate is still uncertain, we believe there remains some insulated pockets of opportunities for investors to gain exposure to REIT sectors where fundamentals remain strong, secular trends are supportive, and existing valuation discounts reflect attractive entry points.

For instance, life sciences office has been more insulated than traditional office space from work-from-home trends given the need for scientists to collaborate in person on the research and development of new drugs. Although higher financing costs have led to a slowdown in venture capital funding for life science companies and consequently lower absorption of space relative to the strong levels of the prior two years, we expect rents to remain relatively stable within most major life science clusters. Cell towers and data centers are also in strong positions and benefitting from the digitization of activities in many areas of the economy, with increasing demand for broadband connectivity and cloud data storage. Access to this property type is primarily through the public markets. As an example, more than 90% of cell towers in the US are owned by public tower REITs. The rollout of 5G and AI applications, as well as the internet of things (IoT) are two key tailwinds for these property types, which historically have enjoyed high barriers of entry.

Finally, we remain constructive on rent growth for the industrial sector over the next year, especially in gateway markets. We forecast strong demand for industrial real estate space will continue, which is supported by growing e-commerce penetration and an undersupply in logistics real estate in many of the key distribution hubs.

It is important to note that not all publicly traded REIT sectors will benefit from increased secular demand drivers. REITs that own standard commodity offices, as opposed to amenity-rich specialty office buildings, will be more impacted by the secular decline in demand due to disruption trends and refinancing headwinds, compared to the sectors mentioned above.

What We’re Watching

 

Non-Bank Lending and Spillovers to the Broader Economy

For almost two decades, loans to US businesses from non-bank lenders such as hedge funds, pension funds and insurance companies have exceeded loans from banks. As of the fourth quarter of 2022, about 40% of all non-corporate business loans were bank loans, down from a peak of 70% in 1983.7 If we assume that losses on CRE loans cause only banks to tighten lending standards, the impact on the US economy should be manageable and recession would likely be avoided. Given the increased dependence on non-bank lenders, however, we also need to consider the potential impact if they also tighten lending standards. For example, CRE loans account for about 11% of investments made by insurance companies.8 Losses on those loans relative to capital could be sizeable and lead insurers to scale back investments elsewhere. In a bearish scenario, where CRE sector stress also leads to tighter credit standards in non-bank lending, we think a recession is highly likely. More broadly, we continue to monitor spillovers to the broader economy from tighter standards for lending to CRE borrowers and are tracking data across stress in the broader financial sector, as well as monitoring financial conditions, consumer spending and confidence.

Headwinds are building for the CRE market. A challenging environment is set to persist in the year ahead, with most pressure likely to apply to the office sector. However, investors should be mindful that CRE remains a diverse asset class. Not all property is created equal, and some segments are better placed to navigate a difficult backdrop than others. To protect portfolios and capitalize on opportunities, we believe it will be vital for investors to monitor near-term risks and identify pockets of resilience where they can be found.

Important Information

1Goldman Sachs Global Investment Research: Guide to CRE Office Debt: Mapping exposures and analyzing property performance. As of April 17, 2023.

 

2Goldman Sachs Global Investment Research. CRE: Will This Time Be Different?” Goldman Sachs Global Investment Research. As of April 10, 2023.

 

3CMBS Weekly: Deconstructing and Demystifying US CRE Exposure,” BofA Global Research. As of April 21, 2023.

 

4 “Quarterly Retail E-Commerce Sales, 4th Quarter 2012,” U.S. Census Bureau press release. As of February 15, 2013.

 

5 “CMBS Weekly: Deconstructing and Demystifying US CRE Exposure,” BofA Global Research. As of April 21, 2023.

 

6 Goldman Sachs Global Investment Research, “Global Economics Analyst The Lending and Growth Hit From Higher Deposit Rates”. As of  April 5, 2023.

 

7Goldman Sachs Global Investment Research, “US Economics Analyst: Small Banks, Small Business, and the Geography of Lending,”. As of April 10, 2023.

 

8US Federal Reserve, Autonomous and Goldman Sachs Asset Management Multi-Asset Solutions. As of March 31, 2023.

 

Disclosures

 

Risk Considerations

 

Investments in fixed income securities are subject to the risks associated with debt securities generally, including credit, liquidity, interest rate, prepayment and extension risk. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price.  The value of securities with variable and floating interest rates are generally less sensitive to interest rate changes than securities with fixed interest rates. Variable and floating rate securities may decline in value if interest rates do not move as expected. Conversely, variable and floating rate securities will not generally rise in value if market interest rates decline. Credit risk is the risk that an issuer will default on payments of interest and principal. Credit risk is higher when investing in high yield bonds, also known as junk bonds. Prepayment risk is the risk that the issuer of a security may pay off principal more quickly than originally anticipated. Extension risk is the risk that the issuer of a security may pay off principal more slowly than originally anticipated. All fixed income investments may be worth less than their original cost upon redemption or maturity.

 

When interest rates increase, fixed income securities will generally decline in value. Fluctuations in interest rates may also affect the yield and liquidity of fixed income securities.

 

Mortgage-related and other asset-backed securities are subject to credit/default, interest rate and certain additional risks, including extension risk (i.e., in periods of rising interest rates, issuers may pay principal later than expected) and prepayment risk (i.e., in periods of declining interest rates, issuers may pay principal more quickly than expected, causing the strategy to reinvest proceeds at lower prevailing interest rates).

 

An investment in Real Estate Investment Trusts (“REITs”) involves certain unique risks in addition to those risks associated with investing in the real estate industry in general. REITs whose underlying properties are focused in a particular industry or geographic region are also subject to risks affecting such industries and regions. The securities of REITs involve greater risks than those associated with larger, more established companies and may be subject to more abrupt or erratic price movements because of interest rate changes, economic conditions, tax code adjustments, and other factors.

 

General Disclosures

 

Economic and market forecasts presented herein reflect a series of assumptions and judgments as of the date of this presentation and are subject to change without notice. These forecasts do not take into account the specific investment objectives, restrictions, tax and financial situation or other needs of any specific client. Actual data will vary and may not be reflected here. These forecasts are subject to high levels of uncertainty that may affect actual performance. Accordingly, these forecasts should be viewed as merely representative of a broad range of possible outcomes. These forecasts are estimated, based on assumptions, and are subject to significant revision and may change materially as economic and market conditions change. Goldman Sachs has no obligation to provide updates or changes to these forecasts. Case studies and examples are for illustrative purposes only.

 

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This material is provided for informational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities. This material is not intended to be used as a general guide to investing, or as a source of any specific investment recommendations, and makes no implied or express recommendations concerning the manner in which any client’s account should or would be handled, as appropriate investment strategies depend upon the client’s investment objectives.

 

Index Benchmarks
Indices are unmanaged. The figures for the index reflect the reinvestment of all income or dividends, as applicable, but do not reflect the deduction of any fees or expenses which would reduce returns. Investors cannot invest directly in indices.

 

The indices referenced herein have been selected because they are well known, easily recognized by investors, and reflect those indices that the Investment Manager believes, in part based on industry practice, provide a suitable benchmark against which to evaluate the investment or broader market described herein.

 

This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. This material has been prepared by Goldman Sachs Asset Management and is not financial research nor a product of Goldman Sachs Global Investment Research (GIR). It was not prepared in compliance with applicable provisions of law designed to promote the independence of financial analysis and is not subject to a prohibition on trading following the distribution of financial research. The views and opinions expressed may differ from those of Goldman Sachs Global Investment Research or other departments or divisions of Goldman Sachs and its affiliates. Investors are urged to consult with their financial advisors before buying or selling any securities. This information may not be current and Goldman Sachs Asset Management has no obligation to provide any updates or changes.

 

Views and opinions expressed are for informational purposes only and do not constitute a recommendation by Goldman Sachs Asset Management to buy, sell, or hold any security. Views and opinions are current as of the date of this presentation and may be subject to change, they should not be construed as investment advice.

 

Past performance does not guarantee future results, which may vary. The value of investments and the income derived from investments will fluctuate and can go down as well as up. A loss of principal may occur.

 

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The possibility of a recession is “still pretty high”, according to PSP Investments’ chief investment officer, Eduard van Gelderen, with that prospect driving investigations into the most impacted asset classes if that eventuated.

“It’s a very delicate situation in the next three years, and we’re looking into the impact that would have on the portfolio,” he says. “We still believe the probably of a recession is still pretty high over the next two years.”

It’s one of a handful of projects the PSP investment team is looking at over the next 12 months as it comes off a stellar year despite the market upheaval.

Increasingly important to the way the portfolio is managed is the aim of minimising and mitigating the risk of a deficit in the plan, van Gelderen says.

Portfolio testing is centred around returns but also negative scenarios that could impact the portfolio and more specifically create a deficit, and subsequently how the portfolio could be positioned to mitigate that.

The fund manages currency hedging at a total fund level, hedging a group of five currencies that behave similarly to the Canadian dollar. Currency added 5.8 per cent to the total portfolio for the year making it the fourth biggest contributor behind infrastructure, private credit, and natural resources.

“The US dollar is important for us, especially when markets take a nose dive,” he says. “Our annual return of 4.4 per cent is pretty good given the circumstances and currency hedging contributed to that.”

The fund continues to focus on risk management and building portfolio resilience.

“With risk people think about market volatility, but we think about it differently,” he says.

The risk of a deficit, and funding risk, is important to the fund, which in turn gives the investment team very different indicators for the portfolio.

“We need to think about the government adding to contributions if there is a deficit, so we look at funding risk not market risk and this gives us very different signals,” he says. “We look at cashflows. As long as positions generate good solid cashflows, the market valuation is not that important to us. Cash generation is more important than the volatility.”

Van Gelderen says PSP’s portfolio is well positioned, and despite the volatility in capital markets, the cashflows generated from real assets are providing protection.

Infrastructure, which makes up 12 per cent of the C$247 billion portfolio, was the fund’s best performer in the financial year results just released.

“With the real assets we have a cashflow focus and look at whether the deals we do are generating an appropriate cashflow we are looking for. One of the reason the asset classes did so well last year in infrastructure and private credit is because the deals have solid cashflow generations. And in infrastructure there is an inflation path through in those deals. That is an important to us.”

In the past year the infrastructure investments generated C$4.6 billion of income, and an increase in assets of C$5.9 billion, with C$1.6 billion of that attributable to currency gains.

Core to the management of the portfolio is the risk tolerance of the Canadian government, PSP’s sponsor, and how each asset class and currencies play a role in managing that risk tolerance.

“Our mandate is not just about maximising returns, there is clearly a risk element to it.”

Focusing on the long term

PSP has outperformed its reference portfolio over the past decade with a 10-year net annualised return of 9.2 per cent versus the reference portfolio of 7.4 per cent. It’s also outperformed on a five-year (7.9 per cent versus 5.5 per cent) and one-year (4.4 per cent versus 0.2 per cent) time frame.

Looking forward van Gelderen is emphasising “more and more we are a long-term investor”.

“The long term is what we find important not the short term,” he says. “We try to stay away from market timing as much as possible. In reality it is never successful, investors are always late and make a lot of transaction costs.”

PSP reviews its policy portfolio every year, with changes driven by the dynamics of asset classes or a change in the risk tolerance of the sponsor.

Van Gelderen thinks the policy mix will remain stable this year and there won’t be any big changes but there are two issues under discussion: the impact of a recession on asset classes; and the impact of climate change on different asset classes over the long term.

The fund also has a dynamic asset allocation process that looks closer at the economic cycle.

“If inflation remains high and more sticky than we hope it will have a massive impact on the liability side of our portfolio. If it remains more sticky then we might move more towards our inflation hedging strategies, that is something we are currently looking into.”

In September last year PSP appointed a new chief executive, Deborah Orida. And in that time the team has made some changes to the team and organisation. From an investment sense there will be more emphasis on the difference between the alpha and beta generating activities, and portfolio completion driven by an internal trading team to create passive exposures.

The fund is split 50:50 between private and public assets with the private asset classes given great freedom to pick the best deals across regions and sectors.

“But by doing it that way they might not follow the country or sector asset allocation for the policy portfolio, so to hedge that gap we have the completion portfolios and tat will be something we emphasise a bit more,” van Gelderen says. “From a risk point of view we can see whether the total portfolio is moving in line with the view of the reference portfolio.”

Talking to Top1000funds.com in an interview following the fund’s “town hall” meeting van Gelderen emphasised the impact of new CEO, Orida.

“She is directing the organisation in a certain way and clearly on the agenda is the culture of PSP,” he says.  “She keeps emphasising our role at PSP and the importance of what we do. People working for the Canadian government do an important job for Canada and we need to support them to be able to retire. Our social licence to operate is front of mind for her and the culture she is creating. And this is important internally, there is a purpose for why we do our jobs.”