How bad could a trade shock be for the industrial sector?
Industrial properties are most susceptible to shifts in global trade, but demand for U.S. warehouse and logistics assets appears to have diversified, perhaps mitigating this risk.
If protectionist policies are implemented, markets with direct ties to port districts are most at risk, especially in Southern California.
While global trade will remain an important driver of logistics and warehouse demand, the overall performance of the U.S. economy will be critical for industrial demand and investment performance.
The United States has a large and diversified economy with strong consumption demand, which may provide its major logistics markets a degree of insulation in the case of trade restrictions.
Nationalist populism takes aim at global trade
Globalization’s inexorable forty-year march was dealt a blow by Brexit and the subsequent presidential election in the United States. Both results captured a wave of populism linked partially to a decade of economic malaise resulting from the global financial crisis of 2008, as well as the sharp increases in income and wage inequality. In the United States, the economic recovery since the financial crisis has been sub-par by historical levels. Wage growth has been flat, labor-force participation levels have remained stagnant, home values in many markets have yet to fully recover. Put another way, it has been an economic recovery where many have been left behind.
Then, in 2016, presidential candidate Donald Trump promised sweeping reform as he vowed to “drain the swamp” of politics in Washington, DC. The items on his immediate agenda included a swift end to geopolitical conflicts that had vexed the United States and its allies; business friendly tax reform; more robust border security; and a trade policy aimed at making domestic companies more competitive by implementing protective tariffs, border adjustment taxes, and exiting trade partnerships like the Trans-Pacific Partnership (TPP) and North American Free Trade Agreement (NAFTA). The rationale for this more nationalistic policy agenda is to level the playing field, and boost economic growth by promoting and supporting U.S. corporations to jumpstart domestic industrial production.
Trade debates are not new
The debate around foreign trade and its impact on the economy is not a new one, but one that has taken on increased importance in the last four decades, back to when the United States last ran a trade surplus. In fact, since 1976, the United States has experienced a trade deficit for goods, while at the same time seeing its manufacturing base erode because companies have found it more cost effective to produce goods overseas where labor, fixed capital, and regulatory costs were far less than in the United States. As Exhibit 1 shows, U.S. trade was modestly negative from the 1970s to the late 1990s and then deteriorated sharply, coinciding with China’s emergence as a global manufacturing powerhouse.
Since the 1980s, the U.S. manufacturing base, as measured by payroll employment, has experienced a steady decline as factories were shuttered and production moved overseas. The impact was felt greatest in the Midwest “Rustbelt” metro areas from Cleveland to Detroit. The secular decline in U.S. manufacturing is evidenced by the contraction in manufacturing payrolls that peaked in 1979 at 19.6 million and are currently at 12.4 million—a 37% decline in workforce. Over the same period however, the U.S. economy has become more service oriented in terms of both payrolls and share of GDP and overall trade. In fact, the economy has not experienced a trade deficit for services since 1970, with exports totaling US$250 billion as of 2016. Over that same period, service payrolls have grown by 88%, or roughly 2.3%, annually, as global demand has increased.
The relationship between trade and economic growth is complicated. From policy and public perception perspectives, however, trade deficits appear to be bad business for domestic firms that face foreign competition for U.S. consumers. Moreover, they undercut potential GDP by subtracting directly from headline growth. Offsetting that, trade also provides important economic benefits to consumers such as lower costs and inflationary pressure because of comparative advantage, as well as the creation of millions of jobs along the North American supply chain in warehousing and distribution.
Trade agreements such as NAFTA are also thought to have helped increase domestic GDP through wage and job growth. The U.S. International Trade Commission estimated that bilateral trade agreements helped increase exports by 3.6%, imports by 2.3%, real GDP by 0.2%, employment by 0.1%, and real wages by 0.3% in 2012.1 In fact, a majority of the U.S. manufacturing jobs lost following the implementation of NAFTA were in low-value-added sectors such as textile and clothing.
If we step back and take a longer-term look at how trade and increased globalization has affected the U.S. economy, it may be best to look at growth created domestically in trade-related industries. For example, trade has nearly doubled since 1990, when the United States was still a relatively closed market, which has allowed significant growth in trade-related industries like transportation and warehousing. In fact, these industries have increased payrolls by 45% since 1990, while all other industries grew by just 32%, as the expansion of U.S. supply chains accommodated the flow of imports and exports through ports, along the path of goods and to consumers.
The industrial real estate market in the United States has benefited disproportionately from the expansion of trade. Imported goods are repackaged and shipped once they are offloaded and require large amounts of distribution space. A surge in imports over the past 30 years has sharply increased the demand for new logistics space and has been a catalyst for new development; the stock of warehouse space in the United States has expanded by 60% since 1990. The expansion of the logistics and distribution system means more job growth and higher demand for modern space in a market where tenant specifications are constantly evolving.
How important is trade to industrial demand?
The Trump administration has vowed to make good on its promise to rework trade agreements thought to be unfair to U.S. corporations, including NAFTA and the TPP. Additionally, Trump has said he will look to implement border-tax adjustments on goods from trade partners it considers currency manipulators. Policies that restrict trade and the flow of goods could have a negative effect on the U.S. industrial markets, particularly on port markets where imports are an important part of the local economy. Demand for warehouse and logistics space could also suffer.
The downside for the industrial market and consumers is that China, Mexico and Canada – the United States’ top-three trading partners in terms of both imports and exports – fall within the cross-hairs of the administration’s sights. The potential implications of tariffs or border tax adjustments would be detrimental to the flow of both imports and exports with these partners. From an economic perspective, this might make short-term sense and potentially stimulate domestic sales, but at a cost of higher inflation through prices on imported goods and potentially higher vacancy rates for types of industrial warehouse space that are dependent on imports. Longer term, truncated domestic pipelines could also preface the loss of distribution jobs since goods would be produced closer to their destination.
Of all the property types, industrial space has perhaps the most nuanced demand characteristics. In fact, most property demand is driven by either employment (e.g., office), population (e.g., apartment), or income growth (e.g., retail). Depending on the market, net absorption of industrial space depends on a myriad of factors ranging from employment, to production, to the housing cycle, to overall GDP growth. Among the drivers that have garnered more significance in the past few decades, however, have been those stemming from increases in global trade activity.
While both imports and exports require significant logistics activity as they are moved from port to port, and ultimately to their final destination, imports tend to spend longer in warehouses whether they are in ports or further along in the supply chain. Based on U.S. trade data back to 1980, imported goods have a 40%2 correlation with net absorption of industrial space, which is itself significant, but not nearly as important as broader indicators of economic activity such as employment and GDP growth. GDP and employment have been the most consistent and significant drivers of industrial demand over the past three decades, which may not be surprising since they tend to paint a more complete picture about the economy and the pace of growth—something that is not always accounted for in overall trade.
For example, if we look at the relationship between imports and demand for industrial space over the past four decades, the relative importance of the correlation has shifted over time. In the 1980s, for example, the U.S. industrial market was recovering from a difficult recession as well as from a shakeup of its domestic supply chain away from export and domestic production, and toward more import-based economic activity. Prior to the 1980s, the U.S. economy was far more insular, and industrial activity was more focused on domestic production and consumption.
The years between 1990 and 2010, however, were marked by a rapid increase in globalization, cross-border capital flows, and trade. The production of lower-value-added manufactured goods moved overseas, where competitive costs in regions like Asia and South America gave corporations a significant advantage. That trend appears to be ending. Nationalism and protectionism are not likely a root cause just yet because we are in the early stages of such policy aspirations in the United States. The more likely causes are market forces, such as the fact that extremely strong growth in emerging markets between 1990 and 2010 pushed wages and costs higher and eroded some of their competitive advantage. Another factor is China’s much slower growth path after to the global financial crisis, pulling back from its breakneck pace of global investment.
Although global trade appears to have peaked in 2008, demand for industrial space has maintained a relatively robust pace in the United States, with consumer spending picking up and the rapid growth of e-commerce rendering an increasing amount of existing logistics and warehouse space functionally obsolete. As a result, demand has shifted to more-modern industrial warehouse space, with companies focused on decreasing delivery times and controlling costs, particularly over the last mile of delivery. The changing market dynamic has allowed the industrial market to decouple, at least temporarily, from global trade; but a prolonged period of falling trade could have broad and negative implications for the economy and industrial market.
Port markets in the cross hairs?
Though the effect of a significant drop in global trade flows through the North American supply chain would be damaging to the domestic industrial market, port markets, especially in Southern California, and those along major access points to the path of goods would be most at risk. Port markets generate significant primary and secondary benefits for warehouse owners and logistics operators through both the flow of goods and the economic growth generated by the port activity in secondary industries. As an example, the Port of Houston moves US$77 billion of goods through its facilities each year, which generates roughly US$264 billion of economic activity throughout the state of Texas.3
Policies aimed at ‘leveling the playing field’ for U.S. businesses would likely slow down the flow of goods and undermine demand in many markets. Port markets with a significant amount of new supply in the pipeline are most vulnerable to this potential disruption in demand. Among the top 20 markets in terms of anticipated demand in the next one to two years, 13 have direct ties to port customs districts and may be at risk if trade and overall economic activity fade because of protectionist policies.
Disruption in trade would certainly have an asymmetric impact on markets. Port markets would appear more susceptible because of their position in the supply chain as an entry point for global goods. In addition, port markets tend to have more robust supply cycles to meet the volume of global goods moving through their facilities. Across the 20 largest trade markets by volume, international goods account for roughly 18% of goods traded. The remainder is inter-metro area trade.
The range of results is somewhat varied, with San Jose experiencing the highest share of foreign trade, at 36%. Non-port market Memphis has the lowest share, with just 7%. On average, these numbers are significant, but they also highlight the importance of domestic trade in generating demand for warehouse space along the supply chain. In fact, increased domestic shipping activity is one reason that the market for distribution space has continued to thrive even as global trade has plateaued in recent years. Domestic shipping is also a factor in lowering the correlation between trade and demand.
Policies to boost growth through reducing imports would certainly reduce trade and distribution demand from global goods, but would not necessarily mean that markets would reset. Trade between metro areas within the United States supports demand for space from domestic sources—even in the largest ports.
In fact, larger economies such as New York and Los Angeles derive less than 20% of their trade from international sources. Even in these markets, the fallout would be uneven and focused on select facilities geared toward international shipping.
Fallout from protectionist and anti-trade policies
The industrial sector is in the midst of a good run, but it is somewhat vulnerable to shocks since we are now relatively late in the cycle. The vacancy rate for the U.S. industrial market is 8%, well below the market’s equilibrium range of 10% to 11%, indicating that landlords still command significant pricing power. While conditions remain reasonably balanced, risks to rent and value growth could become heightened as proposed policies threaten to alter the flow of trade both into and out of U.S. port markets. To this point, however, the new administration has made little progress on its promises to jumpstart growth via ambitious stimulus programs, implementation of tariffs, and the renegotiation of key trade agreements. So far, this is good news for industrial warehouse investors.
It is also beneficial that industrial demand over the past decade has been driven more by broader economic trends such as employment, wage growth, and retail sales growth than it has been by imports and exports. Domestic trade appears to be more important to overall industrial demand than global trade. This decoupling suggests that, barring recession sparked by a black-swan event such as a global trade war, the U.S. industrial market would likely be able to weather moderate declines in global trade.
It is too early to tell whether the Trump administration will be able to accomplish its ambitious trade agenda and what that would mean for U.S.-based businesses. Most national or regional trade agendas or policy platforms containing protectionist sanctions tend to do two things: restrict trade and increase prices. Were restrictions on trade to become a reality, they could negatively affect the industrial sector and cause asset values to decline and income growth to slow. However, given the many competing political agendas in the United States, the chances for a sweeping overhaul in trade policy could be quite small and could diminish through compromises as legislation winds its way through the political process.