Question 2: What is the outlook for commercial real estate?
Answer: We are closely monitoring the commercial real estate (CRE) sector, with particular focus on weakness within the office sector. At this time, we see some continued headwinds for the overall asset class, but as is the case for real estate, location and quality matter. We also see some encouraging trends in non-office sectors. Last, as with all investments, each asset must be evaluated in light of its unique characteristics.
CRE concerns began to broaden during the period of bank stress earlier this year, and many banks with exposure to this sector have increased loan-loss reserves and tightened lending standards (Figure 2). What had been seen as mainly a postpandemic, urban office ground zero has started to spill over more broadly to other forms of commercial real estate. As evidence of this trend, through the third quarter of this year, CRE transaction volumes have slowed to a quarterly pace of $82 billion, a 54% y/y decline.1 Some softening is occurring in the non-multifamily CRE space, with the share of loans behind on payments increasing modestly from 0.5% to 0.8% in the span of a year (as of the third quarter of 2023).2
Office does remain the primary concern, as occupancy rates seem to be stabilizing at just 50% of prepandemic levels.3 Quality is key. The newest and highest quality office buildings in New York City (NYC), for example, are capturing record-high rents. Some estimate that class A+ buildings in aggregate will see a relatively modest price decline of 15%–20%, but lower-quality buildings in NYC and San Francisco have recently traded at 50%–80% discounts to prepandemic values. Properties in the Sun Belt, including cities like Tampa, Orlando, and Dallas, remain strong and have seen vacancy rates rise by less than 1% over the last two years. Also, only around 15% of office loans on bank balance sheets are set to mature in the next two years, helping to minimize the potential near-term impact to the overall economy.4
Within the multifamily space, a record number of new units are in development, which could weigh on property values and rents. Funding challenges have also spread from the office sector to multifamily.5 Yet fundamentals for retail, industrial, and hospitality remain relatively sound.6 U.S. consumers have proven to be resilient amid a strong labor market and they continue to spend on travel, with U.S. hotel occupancy rates expected to reach 63% in 2023, up 0.7% y/y.7 Luxury hotels, in particular, have held up, with vacancy rates declining by 6% over the last two years.8
In aggregate, CRE is an area we expect to see continued weakness. However, we do not believe the office sector will materially impair the overall economy, and we are seeing encouraging trends in other sectors. Also important to note: Bank excess capital requirements have increased considerably since the global financial crisis and we believe that the spate of bank failures earlier this year largely represents an isolated event. In our view, the market has already weeded out those banks with the greatest idiosyncratic risks that are not broadly present in the industry today. Moving forward, we expect the disorderly industry failures of 2023 to eventually give way to orderly industry consolidation which will further strengthen the overall banking ecosystem.
3: What are the portfolio implications of the increased correlation between stocks and bonds?
Answer: The traditional 60/40 stock/bond portfolio has been tested by increased correlations between stocks and bonds. We expect a higher-than-normal correlation to persist into 2024 as inflation and rates normalize. However, once the Fed’s inflation target is in reach—or the economy tips into recession—stocks and bonds should return to their typical historical relationship.
Over long periods of time, stocks and bonds have exhibited a low correlation of just 0.1,9 but the relationship is not stable. There are periods where stocks and bonds have been almost perfectly correlated and times when these asset classes are very inversely correlated. Since 2022, the correlation between stocks and bonds has averaged 0.7 and was above 0.8 as of the end of October. This means an investor has experienced a reduced diversification benefit from owning a combination of stocks and bonds. This can occur during periods of rapidly rising inflation, stagflation (low/negative growth and high inflation), or elevated interest rate volatility, when large and violent moves in rates can push stock and bond returns in the same direction.
In our base case soft landing scenario, the Fed will likely begin to cut rates in 2024. In this environment, we expect both stocks and bonds to perform well, thereby benefiting investors from increased correlations. Once inflation normalizes, the fed funds rate settles back toward the neutral rate, and economic growth slows to trend, we would expect a return to a lower correlation between stocks and bonds, delivering the diversification that investors have come to expect.
Figure 3: Current positioning
High-net-worth portfolios with private markets*