Sure, interest rates are low, but there are still troubling economic indicators you should be paying attention to.

We all saw the housing market pick up strength this year, thanks to lower interest rates. Most prognosticators believe housing will maintain its strength through the winter and well into 2020. Mortgage rates are lower than last year, and recent moves by the Federal Reserve suggest they’ll continue to tick down. Although the Trump trade war with China is projected to weaken GDP growth, Freddie Mac’s September forecast indicates the housing market is healthy and will withstand those impacts.

Seeing the markets from our perch in the Washington D.C./Northern Virginia/Maryland market, I have a bit more caution about where things are headed.

We do expect interest rates to remain low and to dip even lower. Also, the nation’s supply of new housing stock is slowly but steadily increasing. We expect total residential closings to be healthy, although down slightly in 2020 compared to 2019. These are hopeful trends.

But there are four bugaboos that keep me up some nights, and we should all keep an eye on them. They are:

  • A drop in consumer confidence
  • Manufacturing weakness
  • Uncertainty in the political landscape
  • The inverted yield curve for bonds

While there will continue to be regions with torrid demand for housing, in most ZIP codes, the quality of the property and neighborhood will be more important than ever. Hard money lenders like us must remain vigilant about backing only quality projects and sticking to borrowers with reliable track records. It’s definitely not a good time to turn the deal flow valves wide open! Let’s look in more detail about my four concerns around overall economic conditions.

01 Consumer confidence is dropping, despite amazing employment figures.

In September, U.S. consumer confidence fell far lower than expected because Americans are gloomy about the U.S.-China trade war. The Conference Board, an industry group, produces a monthly index of consumer sentiment. Their consumer “attitudes” index dropped from 134 in August to 125 in September. Their “expectations” measure—based on consumers’ short-term outlook for income, business and labor—dropped from 106 to 96. These are pretty stunning considering this summer’s unemployment rate of 3.7 was near a 50-year low.

Yes, consumers have more cash in their pockets with virtually full employment and modest wage growth. But the countervailing pressure is the trade wars. The Trump tariffs are taking a bite out of discretionary income as prices for a wide variety of goods rise. The real pain hasn’t even hit yet. President Trump deferred steeper tariffs on Chinese consumer goods until the holiday season. When consumers get nervous, they put off large ticket expenditures such as cars, kitchen remodels and new homes.

02 The manufacturing sector is the main casualty of the trade wars.

Although the economy is strong in many places, a weak manufacturing sector can indirectly hurt real estate. Manufacturing is getting pummeled by the trade wars: the purchasing managers’ index fell to its lowest level since the Great Recession. This is a signal that the Trump Administration’s bare-knuckle approach to negotiations—to reverse globalization, disrupt supply chains and levy tariffs on major trading partners—is backfiring.

Factories are suffering almost everywhere. The eurozone manufacturing index dropped to a seven-year low. Japan and India manufacturing also declined. China, the world’s second-largest economy, posted the slowest growth rate in nearly three decades. China’s exports continue to decline, despite having devalued their currency to make it cheaper for foreign customers to buy.

03 Political uncertainty may put the pause on some home purchasing. 

Do homebuyers make decisions based on impeachment hearings or presidential campaigns? Not directly. But does political noise have an indirect impact on overall spending behavior that impacts the economy? Absolutely.

Between the democratic presidential primaries and the impeachment hearings, a lot of uncertainty is being heaped on the markets. Markets hate uncertainty because it means more risk.

So far, the U.S. equity markets mostly shrugged off the Trump-Ukraine scandal. This may change over the months ahead with all the boogeymen to unnerve investors in the political environment. For example, a surging Elizabeth Warren candidacy would unnerve Wall Street, Big Tech and pharma. Similar political instability is seen in the UK with the Brexit drama.

The political shocks are likely to keep consumer confidence weak. Taken together, they have the potential to make investors skittish and to impact the real estate market.

04 The Inverted Yield Curve

There’s been lots of chatter recently about this inversion. The yield curve is simply the spread between the return investors get from long- and short-dated Treasury bonds.

During normal times, people pay a lower price for 10-year Treasury bonds than 2-year ones since they lock up money for eight more years. But when investors become fearful, long term bonds seem safer. When demand increases for such long-term bonds, their price goes up. And when its price goes up, its yield—the difference you earn when the bond matures minus the bond’s price—naturally goes down.

When people are fearful of recession, they have less demand for short-term bonds, so those prices drop and yields rise. Conversely, higher demand for long-term bonds cause their prices to rise and yields to drop. That is certainly the case today.

When the yield for a 10-year Treasury becomes higher  than for a two-year Treasury, it is called an inverted yield curve. We had those conditions at the end of August 2019. Historically, an inverted yield curve is a reliable indicator of recession happening over the next 2-3 years.

What Next Year Holds in Store

Of course, the Federal Reserve is watching all these indicators like a hawk. Fearful of recession, it’s reversed course on its earlier strategy of nudging up interest rates and has been carefully reducing them instead.

We expect three more rate cuts of a quarter point each. Without a crystal ball in hand, our best guess is cuts in October, December and midway through the first quarter of 2020. These cuts will help absorb the increasing demand for 10-year Treasurys. For 2020 the 10-year yield is expected to average 1.8%, down from an annual average of 2.1% this year. Reducing the 10-year yield will, of course, help bring mortgage rates  down even further.

Freddie Mac estimates that lower rates will ensure mortgage origination remains  fairly stable at $1.8 trillion in 2020. Thanks to the increasing supply of housing stocks, and growing demand from millennials who want to move out of their apartments, Freddie Mac expects home sales to rise by about 1% to 6.03 million homes next year.

But as I laid out above, the economy has a lot of noise  right now. I wish we could be as confident as Freddie, but there are too many recessionary indicators at large.

For hard money lenders, this level of uncertainty means it’s important to stick with tried-and-true risk management practices. Dig into the security of your collateral. Stick with experienced borrowers who aren’t “learning on the job” in a turbulent economy. Look for deals where you can exit early by having the borrower refinance with a bank after the structure is built but before the project is complete. Diversify with a mix of projects and neighborhoods.

Although 2020 may indeed  be a good year for real estate—and I certainly hope it is—it is hard to argue against prudence and caution in these “very interesting” times.