Short-Term Stimuli Could Pose Long-Term Risks

The U.S. economy has started to receive a double-shot of stimulus: enactment of Quantitative Easing Two (QE2) by the Fed and the extension of the Bush-era tax cuts.  Estimates indicate that they could stimulate GDP growth in 2011 by an additional 1% to 2.5%, although we believe it will be more in the 1% to 1.5% range. The base line growth rate projection of 2.5% could accelerate to 4% or higher as a result, and significantly boost the rate of hiring by U.S. employers.

QE2, which was announced in early November 2010, will total approximately $600 billion of U.S. Treasury purchases through the third quarter 2011. The initial goal of QE2 is to add liquidity to the capital markets, keep interest rates low and encourage more capital and asset investment. The measure is also expected to reduce the U.S. dollar against other currencies, a controversial step that could have serious long-term implications if not managed well.

QE2 has already caused the market to anticipate stronger economic growth – and inflation – over the long term. Long-term interest rates have increased approximately 100 basis points and the U.S. dollar has gained 7% against the Euro since its implementation. While this seems contrary to the goal of the measure, the more important role the policy will play is beyond any short-term effect. The 10-year Treasury was already at 2.5% and was unlikely to drop much lower and the dollar had already fallen 14% since its peak in June 2010 before QE2 was implemented. QE2 should be viewed as the Fed’s insurance policy against a significant rise in interest rates and more liquidity to support the recovery’s transition to the next phase.

The tax-cut extensions will stimulate the economy in 2011 in a number of ways. The American consumer will immediately see larger take-home paychecks as a result of the 2% decline in payroll taxes, employers will receive tax breaks for investing in manufacturing facilities and equipment, and investors will see lower capital gains/dividend taxes. 

Our expectations are that the United States will add approximately two million jobs, a gain of 1.5%, in 2011, compared to growth of 1.1 million jobs, or 0.8% in 2010. In turn, this would stimulate absorption of commercial real estate, accelerating the recovery. We have already witnessed strong net absorption in the apartment market, moderate recovery in demand for retail space and stabilization in the office and industrial sectors. The combination of tax cut extensions and QE2 will accelerate the improvement in property market fundamentals while increasing capital flows to commercial real estate as an attractive investment option for institutions, equity funds and private investors. 

As discussed in my previous blog, capital flows and prices have already climbed for Class A properties in primary markets, particularly for apartments and office buildings, which has started an investor migration to B assets and secondary markets. The combination of the tax cut extension and QE2 will accelerate this trend through more rapid improvement in occupancies due to better economic performance, low capital gain taxes and targeted depreciation allowances. For example, a 15-year recovery period is much better than a 39-year recovery period for qualified leasehold improvements, restaurant buildings, and retail improvements. This should lead to increased appreciation in the Class B and C markets.

All this is positive for 2011. It comes at a cost, however, in terms of increased inflation risk in 2012 and beyond as well as increased national debt. The national debt will have to be reduced eventually to sustain global confidence in the United States, which will require less spending and higher taxes. This reality will reduce the rate of growth in 2012 and 2013, and it will place increased pressure on interest rates to ward off inflation worries. The Fed’s upcoming challenge will be to balance the mopping of excess liquidity just at the right time and at the right pace to prevent inflation and not kill the recovery. Had the two measures not been implemented, the short-term risk to the recovery and possibility of a double-dip recession would have been much higher than they are today.

While economic fundamentals are much stronger and prospects for growth in 2011 have improved, companies remain hesitant to add full-time workers and the cautious attitude reflects a fragile business sentiment. Until confidence shows a sustainable and less fickle pattern, risk will remain elevated, even in the short term.

Hessam Nadji is managing director, research and advisory services at Marcus & Millichap Real Estate Investment Services. Contact him at hessam.nadji@marcusmillichap.com.