November 24, 2023
As we parse 2024 outlooks, we offer this analysis from Schwab regarding four problem areas in the economy/markets. Here is their list of problem areas:
Commercial Real Estate – High-Yield Bonds – Small-cap Stocks – Regional Banks
Commercial real estate
What’s the matter: More than a third of U.S. workers who can work from home now do so full time. As a result, between the end of 2019 and the beginning of 2023, the office vacancy rates in New York and San Francisco alone increased 14.2% and 19.8%, respectively. By 2030, more than 300 million square feet of U.S. office space is expected to be obsolete.
On the financing side, nearly $900 billion in U.S. commercial property debt is set to mature this year and next. Property owners will almost certainly face higher rates, and those who can’t afford to refinance will be forced to inject millions of dollars in fresh capital, sell, or simply walk away. “This isn’t something that gets solved over the next couple of years,” says Kevin Gordon, senior investment strategist at Schwab.
What to do about it: Commercial real estate is a broad category, so to say the entire sector is struggling is an overstatement. “Much of the stress in the sector is around office space, and you can boil down the issues to a handful of big cities,” Kevin says. “As an investor, you have to consider the fuller picture.”
In fact, parts of the market are holding up nicely, thank you very much. Student housing is one such area. Rents are growing by about 9% because of limited supply and strong demand at many colleges. The data centers that are key to the cloud computing and artificial intelligence industries are another bright spot. In the seven main U.S. datacenter markets, leasing rose 40% between March 2022 and March 2023, while vacancies fell to a record low of 3.2%.
High-yield bonds
What’s the matter: Although high-yield bonds have been one of the best-performing areas of fixed income, that strong performance came despite a rise in corporate defaults—a trend that may continue as high borrowing costs weigh on low-rated issuers.
Corporate earnings have faltered in the wake of the Fed’s aggressive interest-rate hikes. Companies in the S&P 500® Index posted year-over-year profit declines for two successive quarters starting in the fourth quarter of 2022—the technical definition of an earnings recession.2 Moreover, corporate pretax profits declined in four consecutive quarters through the second quarter of 2023, according to the Bureau of Economic Analysis.
“Prolonged earnings weakness will hurt the ability of high-yield issuers to find investors willing to refinance their debt,” says Collin Martin, CFA®, a director and fixed income strategist at the Schwab Center for Financial Research. “As it stands, those who issued high-yield debt two years ago are paying double in interest expense now—and it’s only going to get tougher for companies to withstand the increase in their borrowing costs.”
What to do about it: Collin says that older investors who count on investment income to fuel their spending should favor investment-grade corporate bonds rather than high-yield bonds in the immediate term, since investment-grade corporate bond yields are near the highest they’ve been in more than a decade.
Those continuing to hold high-yield bonds should closely examine the specifics, including how the debt is rated, whether it’s secured or unsecured, and whether the market is liquid enough to accommodate a sale. “Even in the high-yield space, you can have big differences in credit ratings,” Collin says. “Ideally, you want to be a bit more defensive and focus on bonds or bond funds that favor higher-rated issues.”
Small-cap stocks
What’s the matter: Unit labor costs — or how much a business pays its workers to produce one unit of output—increased at a rate of 6.3% in the first quarter, compared with just 3.3% in the prior period. That’s an acute issue for small businesses, for whom labor costs constitute some 70% of their spending.
In fact, small businesses repeatedly report that labor shortages are hampering their operations, with many struggling to offer adequate compensation. While the growing economy theoretically enables them to boost sales, there’s a limit to how much they can sell given their capacity constraints.
“The higher core costs that small businesses are incurring aren’t likely to go down as fast as the inflation that’s boosting their sales—and any downturn would likely see small companies’ revenues come under pressure even as their cost of goods sold remains elevated,” says Adam Lynch, a senior quantitative analyst at Schwab Equity Ratings.
Such headwinds are already apparent in the performance of small-cap indexes like the Russell 2000®, which gained about 12% through the first half of 2023, compared with an 18% rise in the broader S&P 500.
Regional banks
What’s the matter: The failure of Silicon Valley Bank in March promptly sent regional bank stocks reeling. Although the KBW Nasdaq Regional Banking Index has since recouped some of its losses based on signs that the crisis was contained, the sector’s problems may not be over.
The core vulnerability stems from the impact of higher interest rates, which undercut the value of the banks’ outstanding fixed-rate bonds and other loans issued when rates were near zero. And despite their best efforts to trim their U.S. commercial real estate (CRE) and construction exposure, regional banks are still the biggest lenders to the commercial real estate and construction markets. Indeed, a study of nearly 5,000 banks’ public regulatory data found that approximately a sixth have either a CRE or construction loan concentration in excess of 300% or 100%, respectively, of their total capital, exceeding regulatory thresholds.
“Commercial real estate and construction is a significant chunk of exposure for smaller banks, and that doesn’t work in a world of sky-high vacancy rates and ever-increasing borrowing costs,” Adam says. “They’re in a tough spot.”
Market Update
Stocks kicked off the holiday-shortened week with a solid +0.7% gain as corporate drama in the land of AI boosted shares of market heavyweight Microsoft and AI favorite Nvidia. Stocks slipped back -0.2% Tuesday with a few retailers issuing cautious outlooks. But buyers stepped in immediately Wednesday to push shares back up +0.4% as interest rates fell for a fifth straight day. Rates on the 10-year note have fallen from 5.0% to 4.4% over the past five weeks. Investors believe the Fed is finished with their interest rate hikes and will begin cutting rates next year if slower economic growth pops up. Also on Wednesday, investors reacted to another AI-driven blowout earnings report from chipmaker Nvidia. But the good news was sold as the stock struggles to push past $500. Note: the stock was trading at $200 back in February before news of the company’s AI success story came out. Coming back from Thursday’s Thanksgiving holiday, stocks traded flat in a half session Friday.
A fourth straight week of gains saw the S&P 500 (SPY) higher by +1.00%. The Nasdaq 100 (QQQ) rose +0.90%. Smallcap stocks (IWM) ticked higher by +0.58%.
Warm wishes and until next week.