In 2018 We Are: (a) Doomed, or (b) in the Warm Embrace of Goldilocks

by Dechert LLP

Around this time of year, we slip on the prognostication goggles and take a look forward into the next year.  While there is ample evidence that prognostication is a dodgy exercise, I always tell my folks that the fact that it’s hard to do and extraordinarily unreliable is not an excuse not to have a view.  To not have a view is actually to have one and just not acknowledge that you do.  It doesn’t matter how unlikely we are to get it right: planning beats clinging to guns, God and Brownian motion as a model for the well-lived life.

And now I will finally admit it — this market has beaten the pessimism out of me.  Because I am a self-appointed, card-carrying member of the chattering class, I need at all times to fabricate intellectual sophistication, cynicism and the ability to use phrases like “Hegelian dialectic” in a sentence (as no one, perhaps including Mr. Hegel himself, actually understood what that means, the chances at being called out are slim).  Consequently, against all the evidence, I clung to a position of balanced neutrality as to the prospects for upside and downside change in the near and middle term.  That’s what the cool, furrowed-brow, corduroy-wearing, kale-chomping, German philosophy-quoting, left bank Ph.D. economic types all say. I stuck with that in 2015, 2016 and 2017.

I give up.  I simply can’t see anything that will knock the continued growth of our economy, and hence, the continued health of the commercial real estate industry and the capital markets, off its current path.  It’s hard to see how this party ends any time soon, and if someone at CREFC breaks into a rendition of “I’m a Cockeyed Optimist” from South Pacific, I’m not gonna smirk.

Oh sure, everything ends.  Entropy is a fundamental characteristic of reality, and even the Trump administration will presumably have a natural end (or at least that’s the plan).  But, right now, it’s hard to see what’s going to knock this Goldilocks economic happy dance off its pins anytime soon.

But just for drill, and as I really hate giving up my defensive crouch, let’s try to make the case for doom or doomishness.

  • First, there’s a lots of crazy folks out there in the world and lots of opportunities for geopolitical shock. Hard to handicap, but none of these shocks are inconceivable. We could collect the usual suspects here: Korea, the South China Sea, Palestine, resurgent Russian revanchism, India and Pakistan, Iran and the Saudis.  With a little less fire and brimstone, what will happen if someone wakes up and realizes that the European Community model can’t be fixed and is irretrievably broken?  Remember: there’s still a half a trillion zombie loans kicking around the European banks, and between the financial trouble in the southern arc of Europe and political turmoil in the east (and not to mention Brexit), it’s far from inconceivable that we could have an Emperor’s New Clothes moment in old Europe.
  • And then closer to home, the Fed will at some point now start to shrink the balance sheet in a meaningful way. We really have no idea what that experience will be like. Speculating about shrinking a $4 trillion balance sheet is like noting “Here Be Dragons” on a 14th century map of the known world.  Maybe it’s a non-event, but maybe not.  On the other hand, we have continuity at the Fed, and a very cautious continuity at that, so it’s hard (but not impossible) to gin up that much anxiety that the shrinking process will accelerate out of control and cause material damage to the economy.
  • The expansion is just long. We haven’t seen many this long, although this isn’t the longest. Long has always indicated the end is nigh, although nigh might take a while.  All expansions come to an end, but on the other hand, the only condition 100% correlated with death is life.
  • We’re too damn happy. There’s going to be 1,600 people at CREFC in January. I think the last time that happened was 2007, and we all know how that worked out.  There’s something about the old adage that those who God wants to destroy they first raise up, and boy oh boy, this has certainly been a great economy.
  • Finally, one should not dismiss the orange swan effect. There’s certainly an unpredictability at the heart of our government that carries with it more than a whiff of volatility and some of that volatility is likely to have unamiable consequences. Writ larger, some major political or constitutional crisis in Washington could certainly disrupt this party.

But I just can’t see a reason to maintain that comfortable, defensive crouch as I enter 2018.  In our practice here at Dechert, all lights are blinking green and the deal flow for the first quarter is already impressive.  We haven’t seen this type of start to a calendar year in ages.  So we’ll plan on growth, aggressive innovation in pursuit of yield on the buy-side, and hot to sell leverage on the sell-side.

And good news for us transactional junkies with a taste for the unallayed joys of complexity: innovation is back in spades and will be a true driver of business this year.  In an expansion that’s as long in the tooth as this, most of the easy money has been made, and to meet investment hurdles now, we expect people to be increasingly innovative (which may, but not necessarily, be a euphemism for less risk-averse) in finding ways to solve problems that might have just been too hard to bother dealing with when making money was just too easy.  We’re seeing aggressive use and growth of CRE CLO technology.  The recently closed billion-dollar Blackstone deal (on which we acted as issuer’s counsel) was a highly innovative CRE CLO and almost certainly a harbinger of continued innovation in 2018.  We’re seeing deals designed to address and manage regulatory capital.  There’s still plenty brain damage around risk retention and the regulatory state, and while perhaps waning, it’s still a powerful force making the otherwise straightforward wonderfully complex.  We’ll see efforts to find more capital solutions in both the residential and construction marketplaces, and aggressive growth in the SFR segment.  We’ll see broader use of synthetics to take views against complicated physical executions.

And we expect to see a year of acquisitions.  For folks with cash and in a hurry, getting scale by buying it will be a motif of 2018.  Those transactions drive the need for leverage and the capital markets will respond creatively to provide it.  We expect to see concentration across capital markets players and the non-bank space, as the reality that scale matters becomes more and more a compelling reality of the business plan.

Net/net, we see lots of transactional activity.  We see people striving to continue to take advantage of Goldilocks while she’s in town, and we’re excited that we’re going to be a part of it.

So that’s our plan, and that’s our view.  I hope we’re right.  Happy New Year.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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