The Macroeconomic Tug of War of Today

In the last several weeks, I’ve had the privilege of speaking with Howard Marks (Co-Founder of Oaktree Capital Management) and Jeff Aronson (Co-Founder of Centerbridge). Two legends in the investing world that I have been following and inspired by for some time. I was lucky enough to get some awesome insights from them and even ask Jeff a question about the impact of technology on distressed investing. We aspire to one day write memos as famous and incredible as Howard’s.

As everybody knows, the world is in a very weird place right now. Nobody has any idea what’s going on behind the scenes in world governments, some businesses are succeeding wildly while others are flailing, liquidity is drying up across public and private markets, and people are unsure of financial (and in some cases) physical survival. Transaction volume across most private markets, but especially real estate, is significantly down. Interest rates haven’t been this high for over a decade but at the same time more capital has been poured into the system than ever before in history. This comes within the neighborhood of $300B in new government spending to bail out failed banks like SVB and $75B in aid to Ukraine since we wrote our “Macroeconomic Approach to Analyzing Volatile Markets (Pt. 1)” article over a year and a half ago in May 2022 predicting these exact sort of liquidity crunches.

Needless to say, we are in an epic economic “tug of war” that is going to result in some prices increasing but most prices decreasing- which we are already seeing. We recently underwrote a multifamily asset in Honolulu that was listed for $3.3m last year and just came back on the market for ~$2.3m. There doesn’t seem to be many markets other than global gateway cities like NYC not experiencing these sorts of price cuts. Apartments in secondary cities like Philadelphia, Salt Lake City, etc. are having trouble leasing up to full occupancy due to many new developments that might be slightly ahead of the demand (or what that demand can currently afford).

It’s unlikely but not impossible that inflation will go negative (causing deflation, like some notable investors have predicted). It is likely though that we will continue to see more illiquid assets like real estate and levered private companies have less attractive valuations from an ownership perspective (which of course means more attractive values from a buying perspective), at least as long as rates stay high. Elijah’s below macro-analysis titled “The Macroeconomic Tug of War of Today,” has also been published on the Wharton Undergraduate Real Estate Club’s website.

Right now we are in a period of “price discovery” for almost every asset in the global economy. This comes after several years of unprecedentedly large government spending followed by the steepest and fastest interest rate hikes in history. While it’s evident the FED has done a great job curbing inflation, many are now starting to wonder if they have gone too far. Is a soft landing still possible? If so, what does that look like for the prices of our favorite assets? The short answer is that it depends.

1. Government spending.

• On one hand, government spending has increased to levels not seen ever before, totaling over $5T in less than the last 5 years. This initially led to inflation across the economy, most notably seen (and experienced) in groceries, energy, and real estate prices.

• On the other hand, the federal government seems to be destroying money on a daily basis with things like the war in Ukraine and now Israel, etc. 

2. Interest rates.

• Similarly to spending, interest rates have never risen faster.

• What most people are talking about is that this means the federal government’s debt payments are now approaching $1T annually. The power of high interest rates should not be underestimated.

• What less people are talking about is businesses (and even individuals in some cases) similarly having much higher debt burdens now than in the last decade plus, and only a very small few are prepared to deal with it.

• Another factor here is investors’ perceptions of where interest rates are going and how much, if at all, those perceptions are already priced into markets. I am personally under the assumption that interest rates will likely stay higher for longer, but it appears that many others disagree with that as evident by macros falling upon the last FED meeting announcing no change in rates (indicating that a rate reduction was previously priced in).

To understand where I am going to take this, it’s imperative to understand the difference between real and nominal value. Given most of you reading this already understand it well, we will keep this explanation simple. Nominal values account for inflation (new money entering a system). Naturally, as new money enters a system, all prices in that system eventually go up. Real values adjust for inflation. A “real” price is adjusted for what an asset would be worth if no new money ever entered the system.

Currently, macros are in an interesting tug of war between real and nominal value. What I mean by this is that over the last several years we have had a tremendous amount of both value creation and value destruction. Some of this value is “real” and some of it is “nominal.” For example, some real value that has been created is AI.

That said, creating real value is oftentimes deflationary, which puts today’s world (of slowing inflation but still high interest rates) in a very interesting position. A serious source of nominal value creation, on the contrary, over the last several years has been the unprecedented amounts of money printing by governments worldwide but especially the United States (that, don’t forget, must somehow be repaid)…