How the changing world order could keep the cost of capital high for years

Horizons article
August 15, 2023

A key question that any investor will be answering daily is if a specific incident is part of a structural trend. Whenever investors witness an event like a technological breakthrough or a radical policy proposal, they will ask themselves whether it is a signal of a structural trend towards the future – or just noise they should ignore. Amid such uncertainty, there is both the risk of seeing insignificant signals as structural trends (which means the investor will act too quickly), as well as the risk of seeing meaningful signals as noise (which means the investor will act too slowly).

An example is the following question: to what degree are we in the midst of a cost of capital crisis? Because of the rapid rise of interest rates in the past year-and-a-half, investors are worried about commercial real estate (in particular offices), whose projects are mainly financed through debt and therefore vulnerable to a rising cost of capital. Indeed, the value of American offices, which was already under pressure because of the working-from-home trend that began during the COVID-19 pandemic in 2020, has declined significantly since the Federal Reserve began raising interest rates in March of 2022.

Source: Bloomberg Finance L.P.

JLL, a global real estate services company, estimates 90% of offices in New York City, the world’s largest office market, are in financial distress. Meanwhile, the amount of deals in commercial real estate (both offices and retail) has declined by more than 50% compared to a year ago – both in the United States and in Europe.

Given the high level of optimism in financial markets more broadly, most investors seem to believe the cost of capital crisis will remain limited. In their view, it is not a structural trend, and therefore ‘noise’. However, we see reason to doubt this. Indeed, the cost of capital could remain higher for longer and therefore repeatedly cause more problems in the near future.

The main reason for this is geopolitical. In the book The Price of Time: The Real Story of Interest (2022), the author Edward Chancellor argues that globalization has been a key driver of the low cost of capital of recent years. His reasoning is that when countries are comfortably trading with each other, the cost of producing goods falls and the bargaining power of working people in developed countries declines (as companies can shift their supply chains to countries with low wages). This leads to lower inflation. In turn, lower inflation allows central banks to lower interest rates, which lowers the cost of capital for, in our example, commercial real estate developers.

However, the future could look very different as countries are no longer comfortably trading. Indeed, governments across the world are supporting the idea of de-globalization by investing in autarky (or self-sufficiency), as well as its mild variant of friendshoring. From the United States to Europe, hundreds of billions of dollars are being allocated to produce energy, metals, batteries and semiconductors closer to home. Most importantly, the prices of these goods will be raised. For example, according to a report by the Taiwanese newspaper DigiTimes, American businesses will have to pay up to 30% more for TSMC’s semiconductors made in America than for those made in Taiwan, TSMC’s home base.

All of this points to a key insight for investors. If our changing world order, which is characterized by international conflict and the relocation of supply chains, keeps raising the costs of resources like energy, metals and semiconductors, both inflation and interest rates will remain higher for longer. This will turn relatively high costs of capital into a structural trend and lead to problems for businesses that have optimized their capital structure for a low cost of capital environment. Indeed, what should worry investors is that the distress in commercial real estate may not simply be noise. The refinancing risk of businesses could remain high for years, which could trigger more cost of capital crises (in other areas) in the future.


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