Our Insights of Future: 2024 Global Outlook

Jan 30, 2024

TABLE OF CONTENTS

1/ SUMMARY

2/ CHINA

• The Importance of the Real Estate Sector to the Chinese Economy
• Policy: Mild Loosening
• Business Sector: Facing Operational Challenges
• Residential Sector: Weak Consumer Willingness and Capacity
• Outlook: Economic Recovery Hindered

3/ UNITED STATES

• The Significance of Real Estate to the U.S. Economy
• Policy: Fiscal Stimulus Far Exceeds the Needs of Output Gap
• Business Sector: Corporate Resilience in High-Interest Rate Environment
• Residential Sector: Facing Structural Housing Shortages
• Outlook: Housing Prices and Wages Pose Potential Inflation Risks

4/ JAPAN

• The Importance of the Real Estate Sector to the Japanese Economy
• Policy: Breaking Free from the Deflation Quagmire
• Business Sector: Operation Shows Sign of Recovery
• Residential Sector: Mild Rebound in Consumer Demand
• Outlook: Sustained Moderate Economic Recovery

5/ APPENDIX 1: TRIGGERING EVENTS FOR RESURGENT INFLATION RISKS IN THE UNITED STATES

6/ APPENDIX 2: CHANGES IN HOUSEHOLD COMPOSITION IN JAPAN

SUMMARY

From a global perspective, the real estate sector makes a significant contribution to GDP. Based on recent average data, the real estate sector contributes approximately 20% to China's GDP, around 15% to the United States, and approximately 12% to Japan. In other developed countries, the real estate sector's contribution to GDP has averaged around 10% over the years. As a crucial pillar in economic activities, the real estate sector not only connects numerous businesses in the supply chain but also has a significant impact on financial institutions such as banks through corporate and residential loans related to the real estate market, collectively forming a stable part of the financial system. On the demand side, housing serves as an asset meeting residential needs and provides residents with the potential for asset appreciation. The health of the real estate sector holds key significance in reflecting the global economic situation.

Reviewing the economic trends in China in 2023, various macro-stimulus policies were implemented at all levels, including, but not limited to, reducing down payment ratios, lowering loan interest rates, lifting purchase restrictions, and optimizing the use of housing provident funds. However, the market continued to weaken, revealing insufficient willingness and indicating internal demand issues, contributing to an economic slowdown. Looking ahead to 2024, we believe China's economy remains in a period of consolidation at a low level, with the real estate sector making limited contributions to the economy. This is primarily due to the constrained policy space for interest rates in China, where rate cuts are expected but likely to be modest. Additionally, considering the subdued willingness of residents to purchase homes, from the demand side, the housing market still faces challenges in terms of sales.

Reflecting on the 2023 economic trends in the United States, inflation has receded from 6.4% to 3.4%. However, being an economy driven by domestic demands, the lingering effects of excessive fiscal stimulus and structural housing mismatches persistently propel wage and housing price growth beyond expectations, even post-pandemic and external shocks. The prevailing high-interest-rate environment is projected to continue into 2024. Looking forward, we anticipate the U.S. economy to sustain resilience, possibly experiencing further inflation. The Federal Reserve is likely to maintain a "higher for longer" approach to address labor demand and wage pressures in sectors such as construction and services, contributing to ongoing housing price increases. This gradual uptick in housing prices is expected to bolster the robustness of the U.S. economy. Therefore, we believe that interest rate cuts will not commence until at least Q3 2024.

Reviewing the economic trends in Japan in 2023, Japan is poised to emerge from deflation. According to the BOJ report, the sustained and stable negative interest rates have played a role in encouraging residents to invest and consume. Japanese inflation is showing signs of improvement, driven by the combined forces of rising external import prices and internal price increases. This improvement is further enhanced by spring negotiations resulting in wage increases, property prices rebounding, and the real estate market contributing consistently to the economy. Looking ahead to 2024, we anticipate more signs of economic recovery in Japan, with a warming CPI prompting the BOJ to exit the era of negative interest rates. The real estate industry will continue to face relatively minor development constraints, providing ongoing vitality to economic growth.

CHINA

The Importance of the Real Estate Sector to the Chinese Economy

Real estate is a crucial pillar of the Chinese economy, playing a significant role in contributing to its overall economic output. In terms of GDP contribution, the real estate industry accounted for around 20% of China's GDP in 2022 (completely contributed). Given the extensive involvement of various industries in the upstream and downstream of the real estate industry's supply chain, it often stimulates the development of related industries such as finance, wholesale, and building materials. The direct contribution of the real estate sector, including both residential and commercial properties, is approximately 6.1%. When considering the indirect contribution by factoring in related industries influenced by the real estate sector, the estimated overall contribution to GDP is roughly around 10%. According to data from the National Bureau of Statistics, as of the first half of 2023, the real estate sector's share of GDP is 7.1%, and the overall industry chain contributes to 23.4% of GDP. Internationally, developed countries like the United States, the United Kingdom, and Germany typically have a higher share of real estate in their GDP, indicating a greater contribution of the real estate sector to their economies. This is primarily because China has not completed its urbanization process, and related industries are still developing, emphasizing the importance of the real estate industry to China's economic development. In China, real estate is not only a basic necessity but also an investment tool. It is influenced by market dynamics and government policies, and its impact on the Chinese economy is intricate. Given its interconnected nature, the real estate sector affects government revenue, corporate debt, and residents' investments, among other aspects. By observing the current state of the Chinese real estate industry, we can analyze its implications for China's current and future economic trends.

Policy: Mild Loosening

The implementation of reserve requirement ratio cuts and interest rate reductions indicates a tendency toward a mild policy loosening, though the space for liquidity release is limited. Faced with deflation concerns, China implemented two reserve requirement ratio cuts in 2023, on March 27th and September 15th, each lowering the ratio by 0.25 percentage points. On June 20th, both the 1-year and 5-year Loan Prime Rate (LPR) were lowered by 10 basis points, and on August 20th, the 1-year LPR was unilaterally adjusted downward by 10 basis points to 3.45%. Notably, on August 21st, the LPR exhibited an unexpected asymmetric "interest rate reduction," surpassing market expectations. LPR, formed by adding points to the Market Lending Facility (MLF) rate in a market-oriented manner, typically follows the MLF rate adjustments. The decision to keep the 5-year LPR unchanged beyond expectations signals a unique message. We believe the "1 down, 5 unchanged" approach of the LPR expresses China's short-term desire to stimulate economic growth, particularly in restoring normalcy to the real estate market. However, the unchanged long-term LPR reflects the People's Bank of China's "wait-and-see" attitude toward economic development, possibly driven by significant pressure on banks' net interest margins. Simultaneously, from an interest rate perspective, the MLF, along with the LPR, has reached historic lows since 2016 (Figure 1). Additionally, it is worth noting that the M2-M1 gap continues to widen. Non-bank deposits (deposits in the banking sector from industries such as securities, insurance, trusts, and funds) have increased significantly, indicating a deepening shift from demand to time deposits by both enterprises and residents. The reduced liquidity and exacerbated idle funds problem essentially reflect a weak real economy with insufficient demand for funds. Due to China's central bank's long-standing stable monetary policy, we believe the space for liquidity release through interest rate cuts is limited.

In 2023, favorable policies were frequently introduced, marking a shift towards a more relaxed environment in the real estate market. However, substantial measures are still pending implementation. During the first half of 2023, the central government did not roll out significant stimulus policies; instead, the implemented policies mainly involved adjustments and optimizations based on existing policies. It was not until July 24th, when the Central Political Bureau of the Communist Party of China declared a "significant change in the supply and demand relationship in the real estate market," those heavyweight policies such as recognizing homes without considering loans, lowering down payments, reducing interest rates, and lifting restrictions were successively released. Relief policies, including extending the deadlines for the 16 financial measures and formulating a whitelist for real estate developers, were introduced. Both the central and local governments have unveiled numerous favorable policies, creating a sustained loosening policy environment. According to relevant statistics, as of 2023, provincial and municipal governments have introduced over 800 adjustment policies, covering more than 330 cities. However, due to factors such as the slowdown in China's economic growth, tightened employment and income after the pandemic, the impact of favorable real estate policies may not be as direct in stimulating a market rebound compared to interest rate reductions. More substantive measures are still awaiting implementation.

Business Sector: Facing Operational Challenges

Businesses are facing operational challenges as optimistic expectations in the real estate market decline, and sluggish sales performance persists without dissipating. The National Real Estate Prosperity Index, abbreviated as the country's real estate development industry's comprehensive prosperity index, has been consistently decreasing since the beginning of 2023 (Figure 2). The index remained below 100 for the entire year and dropped to 93.4 in October, hitting a post-pandemic low, confirming the decline in optimism about the real estate market. Looking at the specific performance of the top 100 real estate enterprises in 2023 (Figure 3), the total sales amounted to 6.2791 trillion yuan for the full year, a YoY decrease of 17.3%. Among them, nearly 70% of enterprises experienced a YoY decline in annual performance, with 31 companies showing a decline of over 30%. Examining monthly sales data reveals a sharp downturn in market conditions starting from April, following a low-level uptick in the first quarter of the year. The market continued to decline in the second half of the year, resulting in a bleak overall performance for the year. According to data compiled from the People's Court Announcement Network, over 220 real estate companies released bankruptcy documents in 2023. Most of these are small and medium-sized real estate enterprises in third- and fourth-tier cities, but some are well-known top 100 enterprises. The number of real estate companies with sales exceeding one trillion yuan in 2023 has dropped to just 16, reaching the lowest level in seven years.

Inability to recover from accumulated challenges, the development model leads to today's bitterness. During the golden age of China's real estate development in the past few years, the main model of real estate companies' expansion was high leverage, high turnover, land hoarding, and scale expansion. This brought about the characteristics of high inventory, high leverage, and high risk in the Chinese real estate industry. In recent years, with policy tightening and the cooling of the property market, the model has ultimately exacerbated the debt and funding chain problems for real estate companies, leading to liquidity crises and debt defaults for several top real estate companies starting from the second half of 2021. New house sales generally adopt a pre-sale system, where real estate companies can pre-sell houses under development to buyers. Buyers need to pay the full down payment at once during the home purchase process, and the remaining house payment is paid at once using a bank loan. In this model, real estate developers receive the entire house purchase amount before the houses are even built, greatly shortening the funding cycle for real estate companies. Usually, real estate companies can start receiving payments about 1-3 years after acquiring land when they obtain pre-sale permits. Although there are regulations that specify that the related funds must enter a regulatory account and cannot be used, in actual project development, the unauthorized use of pre-sale regulatory account funds is not uncommon. Real estate companies use project expenses as a pretext to obtain regulatory funds and then invest these funds in further developing projects elsewhere. Through this method, real estate companies effectively increase leverage. In the era when real estate companies were frantically acquiring land and expanding, this approach became a unique trend. However, since the second half of 2021, issues with this model have started to surface due to factors such as policy and market changes. As the government started to regulate the real estate market, real estate companies faced cash flow constraints. They started selling at discounted prices and reducing land acquisitions. With falling house prices, homebuyers continued to wait and see, leading to the halt and abandonment of under-construction projects, breaking the funding chain. This further undermined consumer confidence in buying homes, creating a vicious cycle that eventually led to cash flow breaks, loss of control in operations, and debt defaults. From 2023 onwards, the scale of domestic bond defaults by real estate companies is 226.77 billion yuan. Out of the 230 bonds that defaulted, 102 experienced substantial defaults and 128 received extensions. Looking at specific companies, domestic bond defaults were mainly concentrated in major real estate companies such as Evergrande, Shimao, Longfor, and Sunac. In 2023, a total of 38 overseas bonds experienced substantial defaults or extensions, with a total scale of 16.04 billion US dollars. Taking China's leading real estate company, Evergrande, as an example, according to its latest disclosed data, by the end of November 2023, Evergrande had accumulated around 316.39 billion yuan in outstanding maturing debt. Evergrande's financial report for the first half of 2023 showed that as of June 30, the company's main operating income was approximately 1281.8 billion yuan, net profit was -33 billion yuan, cash, and cash equivalents were around 40.47 billion yuan, and total assets were 1.744 trillion yuan, with current assets being 1.5785 trillion yuan, and total liabilities were 2.3882 trillion yuan. As a representative of China's real estate, Evergrande is currently unable to achieve profitability to repay its debts. Considering the current sluggish sales data, Chinese real estate companies need time and effort to overcome this predicament, let alone discuss taking up the banner of economic development.

The real estate downturn affects everyone, dragging down economic growth. The sluggish sales of real estate companies have a far-reaching impact on the market, financial institutions, and beyond. When the funding chain of real estate companies breaks, and projects are abandoned, related trust products may be unable to pay interest on time, leading to a potential financial institution crisis. For example, in 2023, China's iconic financial conglomerate, Zhongzhi Group, faced a crisis. Zhongzhi's profit model primarily involved investing raised funds in the real estate industry. However, with the turbulence in the current real estate sector, companies like Evergrande, Sunac, and Shimao, where Zhongzhi had invested, encountered operational issues. This resulted in Zhongzhi facing severe debt exceeding its assets, significant ongoing operational risks, and ultimately a suspension of product redemption, affecting a scale of around 350 billion yuan. Moreover, due to the downturn in the real estate sector, the sharp decline in income from the transfer of state-owned land use rights has had an impact on local government revenue (Figure 4). From January to November 2023, income from the transfer of state-owned land use rights was 4,203.1 billion yuan, a year-on-year decrease of 17.9%. Local government financing platforms in China need to repay a record-breaking 4.65 trillion yuan worth of bonds this year. The dwindling income will make it even more challenging for local governments to meet their financial obligations.

Residential Sector: Weak Consumer Willingness and Capacity

Consumer willingness and capacity are both weak, leading to a softening in the sales of commercial properties. According to data released by the National Bureau of Statistics, the sales area of commercial properties in 2023 was 111,735 million square meters, a year-on-year decrease of 8.5%. Residential area decreased by 8.2%; sales revenue was 116,622 billion yuan (Figure 5), a YoY decrease of 6.5%, with residential sales revenue falling by 6.0%. Since the outbreak of the pandemic, the sales of commercial properties have faced challenges. Despite brief signs of recovery under policy stimulation, the weak willingness and capacity of residents to consume have not been able to reverse the challenges facing real estate sales. This further confirms our earlier explanation that, despite the frequent emergence of various favorable policies, the support momentum is insufficient, and the real estate market's recovery will take time. Looking at purchasing intentions, residents buy properties for the purpose of residence or investment. The significant weakening of property sales may stem from a simultaneous decline in demand. In terms of the rigid demand for self-occupation, even if there is the ability to buy a house, consumers are in a wait-and-see situation due to the lack of an upward trend in housing prices. Such consumers expect further price declines, and news about real estate companies' defaults and uncompleted buildings will negatively impact residents' willingness to consume. Under the current social trend, around the age of 30, the main homebuyers are influenced by the "lying flat" ideology, further suppressing the willingness to purchase real estate. Even from the perspective of buying property as an investment, national housing prices have continued to decline in recent years. Even in first-tier cities, which were considered able to withstand a downturn in prices, prices have fallen by around 15%-20% from their peak, not to mention second-and third-tier cities. Regardless of the perspective, purchasing intentions will remain at a low level until the real estate market experiences a sustained recovery.

The high housing price-to-income ratio makes buying a house challenging despite the desire. In 2023, the average disposable income per capita for Chinese residents was 39,218 yuan, representing a nominal growth of 6.3% compared to the previous year. After adjusting for price factors, the real growth was 6.1%. Breakdown by urban and rural areas shows that the average disposable income per capita for urban residents was 51,821 yuan, with a growth of 5.1% (4.8% real growth after adjusting for price factors). For rural residents, the average disposable income per capita was 21,691 yuan, reflecting a growth of 7.7% (7.6% real growth after adjusting for price factors). Calculated monthly, the average income for urban and rural residents was 4,318.42 and 1,807.58 yuan, respectively. Comparatively, in December 2023, the average price for newly built residential properties in the top 100 Chinese cities was 16,220 yuan per square meter, and for second-hand homes, it was 15,315 yuan per square meter. Although property prices have seen some reduction in recent years, the modest decrease, considering the high baseline, has not been sufficient to stimulate consumer willingness to purchase. Examining the housing price-to-income ratio, which represents the ratio of housing prices to the annual income of urban residents' households, a ratio between 6 and 8 is generally considered reasonable. However, data from 2023 published by Numbeo indicates that China's housing price-to-income ratio is 34.6, more than twice that of Japan, three times that of Germany, and nearly seven times that of the United States. Major cities like Shenzhen and Beijing have ratios as high as 43.5 and 41.7, far exceeding other countries globally. Additionally, China's mortgage interest rates are among the highest globally. According to Numbeo's data for 2023, in the world's major 332 cities, the ratios of mortgage loans to income for residents in Shanghai, Beijing, Shenzhen, and Guangzhou are 369.6%, 361.6%, 316.1%, and 297.7%, respectively, ranking them 15th, 17th, 19th, and 20th. In contrast, London, New York, and Tokyo residents have ratios of 108.7%, 84.2%, and 70.2%, placing them beyond 130th place. Analyzing a specific example, if someone wants to buy a 100-square-meter house with an average second-hand home price, with a down payment of 460,000 yuan and a loan of 1 million yuan over 30 years, the monthly repayment would be at least 5,232.48 yuan with equal principal and interest. In other words, to afford this house, one not only needs an income above the average level but also must cover daily expenses every month. Even if a couple shares the mortgage, it becomes a 30-year commitment. This is only for the average level, and in cities like Beijing, Shanghai, Guangzhou, and Shenzhen, it is even more challenging to own a home. Although property prices have dropped somewhat, the increase in residents' income is not sufficient to cover the housing prices, resulting in a persistently high housing price-to-income ratio. Coupled with China's high mortgage interest rates, residents, even if willing, find it difficult to afford a mortgage.

Outlook: Economic Recovery Hindered

Looking from the policy perspective, the space for monetary policy to exert force is limited, and substantive policies urgently need implementation. Looking ahead to 2024, the loose monetary policy of the People's Bank of China is expected to continue. However, given the central bank's historically prudent policy stance, there may not be much room for significant interest rate cuts or adjustments to mortgage rates. Therefore, in comparison, substantive policies related to the real estate market are urgently needed. The market critically requires reforms in the pre-sale system and measures such as strengthening the supervision of pre-sale funds for commercial housing to inject a strong stimulus and restore confidence among homebuyers. In the current loose policy environment, there is still room for further optimization of certain policies in 2024. It is expected that the down payment ratios for first-time and second-time homebuyers in core first- and second-tier cities will be further lowered. First-tier cities may also optimize home purchase restrictions again. Additionally, addressing the risk of project delivery remains one of the key concerns in 2024. Strengthening the supervision of pre-sale funds for commercial housing and reforming the pre-sale system will be important complementary measures to ensure successful project delivery. The Ministry of Housing and Urban-Rural Development has already clarified that cities meeting certain conditions can pilot the sale of existing houses. In 2024, more cities are expected to promote the sale of existing houses, accelerating the process of pre-sale system reform. The Governor of the People's Bank of China has also announced measures such as reserve requirement ratio cuts and targeted interest rate reductions in February to repair the market and boost confidence. Despite the intensified favorable policies, the overall downturn cannot be solved solely through real estate policies. Factors such as slowing income growth, a sluggish market, and uncertain confidence all contribute to downward pressure.

From the perspective of enterprises, financing difficulties and a weak operating environment make the road to recovery extremely challenging. Despite repeated emphasis by relevant authorities on treating all types of real estate enterprises equally to meet their reasonable financing needs, the actual financing environment did not show signs of improvement in 2023. Non-bank financing for real estate enterprises amounted to 7,222.7 billion yuan, a year-on-year decrease of 15.1%. Looking at the issuance structure, state-owned and central enterprises dominate the credit bond issuance, accounting for nearly 90%, with a year-on-year increase of 6.6%. In contrast, private enterprises and those with mixed ownership have a very low market share. Despite repeated mentions of supporting private enterprises in bond issuance, their level of issuance remains low, with limited coverage and an inability to meet the needs of numerous enterprises. Only a few high-quality real estate enterprises can issue overseas bonds, making this path inaccessible for most ordinary companies. With the downturn in the industry and the cautionary tale of Zhongzhi Group in the trust sector, investment institutions have become more cautious, leading to a substantial decrease in overall investment scale, and financing channels are virtually nonexistent. In the current period, the restoration of homebuyer confidence is still pending, and sustained sluggish sales are a high probability event. For most real estate enterprises, debt restructuring and extension, as well as stabilizing cash flow, remain the most critical tasks. Seeking new breakthroughs and achieving additional growth are secondary considerations. With the real estate sector in a slump, other industries lack the strength to support economic development. When the real estate giant, contributing 20% of GDP, falters, it is challenging to identify a second industry capable of vertically and horizontally transmitting benefits to numerous symbiotic industries to carry the banner of economic development. The highly anticipated new energy vehicle industry is still in the development stage, with a low market penetration rate, currently contributing less than 2% to GDP. Even if the penetration rate increases to 80%, it can only contribute around 5%. In the absence of a successor, we believe that 2024 will remain a challenging year.

From the perspective of residents, confidence is difficult to restore, and they continue to adopt a wait-and-see approach. Affluent residents believe that property prices have not yet reached their lowest point and no longer hold investment value. No one wants to be the last one to invest in real estate, and many prefer to keep their money in banks, waiting for a better buying opportunity. Residents without sufficient funds, facing a more severe economic situation after the pandemic, prioritize employment and income concerns, making housing purchases an unaffordable consideration. Furthermore, the younger generation, as the main force in homebuying, is becoming increasingly resistant to the idea. With a lack of willingness to buy, there are no transactions, and no liquidity, and another vicious cycle ensues. Additionally, in the current macroeconomic downturn, residents' income growth is below expectations. With concerns about job stability and income, even those who choose not to buy houses are reluctant to divert their money elsewhere. The lack of confidence among residents cannot be reversed by policies such as lowering mortgage interest rates, as they do not address the fundamental issues.

We believe that the Chinese real estate market will still need to undergo a period of pain in 2024. Despite the continuous introduction of favorable policies, the economic weakness coupled with excessively high housing prices has made it increasingly difficult for residents to afford homes. Even after multiple reductions in loan interest rates, the sales volume of commercial housing has not shown significant growth, proving that thin policy stimuli alone cannot stimulate residents' willingness to buy homes. For the corporate sector, the primary task remains survival, controlling debt to ensure project completion, rather than focusing on how to develop under the pressures of debt repayment and sluggish sales. In the coming year, the Chinese real estate market will experience the pains of a downward adjustment. The era when real estate dominated economic growth is gone, and it is challenging to identify industries that can replace real estate in supporting economic development. Sectors like clean energy are still in the early stages of development, representing the cost of the past few decades' golden era. Although the long-term structural adjustment of the real estate sector is beneficial for macroeconomic development, it remains a challenging year in 2024. Looking ahead to 2024, we believe that the Chinese economy is still in a period of low-level consolidation, and the real estate industry's contribution to the economy is limited.

UNITED STATES

The Significance of Real Estate to the U.S. Economy

The broad real estate industry in the United States contributes significantly to the GDP, accounting for 14%-16%. Notably, residential investment constitutes 4%-5% (Table 1), encompassing activities such as new home construction, existing house renovation, and brokerage fees. According to the Bureau of Economic Analysis input-output tables, the construction sector has the most substantial impact on various industries, including metal, non-metallic minerals, technical services, and wood. Real estate services, representing 10%-12% of consumption spending on housing services, include leasing, real estate agency & brokerage, and property valuation management. The real estate services market is more developed, with a primary focus on existing home transactions, as new home sales constitute less than 20% (Figure 7). Consequently, compared to the construction sector, which propels the tangible economic chain, the service sector in the U.S. is more advanced, yet its multiplier effect on the real economy is not as pronounced as in Japan and China. The market for new home builders is small and decentralized, with the National Association of Home Builders (NAHB) reporting that over 80% in the U.S. are independent contractors.

Policy: Fiscal Stimulus Far Exceeds the Needs of Output Gap

The year 2021 marked a period of aggressive monetary easing in the United States. Apart from the 0% interest rate, President Biden's three major fiscal stimulus packages totaled a staggering $6 trillion. Correspondingly, U.S. housing prices surged by 40% from 2021 to the first quarter of 2022, until rate hikes curtailed the demand. The three fiscal stimulus policies include the $1.9 trillion COVID Relief Bill introduced by the Biden administration in early 2021, the $2.3 trillion American Jobs Plan aimed at robustly supporting infrastructure, and the $1.8 trillion American Families Plan. Notably, the American Jobs Plan allocates $621 billion for road and bridge investments, $311 billion for water and power grid investments, and $378 billion for housing construction. To alleviate financial pressures and enhance disposable income, the plan includes $400 billion to support workforce development and increase caregiver wages. Simultaneously, the American Families Plan encompasses significant reductions and waivers for tuition, ranging from preschool education to community college, significantly easing the burden on families burdened by substantial student loan debt (the total U.S. student loan debt amounted to a staggering $1.63 trillion as of Q3 2023).

1/3 of quantitative easing (QE) is directed towards purchasing Mortgage-Backed Securities (MBS), flooding the real estate market with substantial liquidity. Since March 25, 2020, the Federal Reserve embarked on steep support for MBS, increasing holdings from $1.8 trillion in early 2020 to $2.6 trillion by the end of 2021, reaching a peak of $2.7 trillion in April 2022 (Figure 8). By the end of 2023, institutions holding MBS witnessed robust excess return rates, hitting near 20-year highs (Figure 9).

Despite a steep increase in interest rates, their suppressive effect on the real estate market remains extremely limited. The underlying reason lies in the excessive fiscal support for the real estate sector, coupled with a scenario of weak housing supply and robust demand, resulting in rapid inflation unique to the real estate market. This inflationary trend is driven by both cost escalation and demand-pull. Examining the data, when the Federal Reserve's benchmark interest rates experienced a sharp uptick (Figure 10), housing prices only declined for approximately six months before rebounding. Extending the timeline (Figure 11) reveals an unusually steep growth trajectory in housing prices since 2020, with a negligible dip in the span of six months that failed to revert prices to the growth trajectory seen before the pandemic. Housing, accounting for 17% of the Personal Consumption Expenditures (PCE) - a key source of inflation stickiness - has played a crucial role. Since the Federal Reserve began raising interest rates in 2022, by the end of 2023, three PCE indicators have shown a rebound: motor vehicles and parts, transportation, and housing. After reaching its lowest point in March 2023, housing costs have stabilized and started to rebound. This implies that apart from disruptions in transportation costs due to the Russia-Ukraine conflict, housing will continue to contribute to inflation through factors like rent. Considering the lag in the transmission of housing prices to rents (as rental contracts typically span six months to a year before renewal), it is likely that housing prices will persist as a high-probability driver of sticky inflation.

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Business Sector: Corporate Resilience in High-Interest Rate Environment

The operational health of real estate enterprises remains robust, with stable leading indicators such as construction commencement rates. Focusing on real estate enterprises, we categorize them into two major groups: real estate intermediaries (Brokerage & Franchise) and home builders. Selected representatives for the vast real estate intermediaries in the U.S. include Redfin and Prologis Inc., while D.R. Horton and Lennar Corp. represent the home builders (Table 2). From Q4 2022 to Q3 2023, net income, excluding seasonal revenue fluctuations, not only remained unimpaired but also showed a slight increase. As a leading indicator for the real estate sector, the commencement rate in 2023 has exhibited a normal upward trend compared to pre-pandemic disruptions. It can be asserted that the current state and outlook of the U.S. real estate market appear stable.

The stability of real estate enterprises naturally extends to their foundation - the residents and their mortgages, which remain healthy. Consequently, unexpected increases in MBS default rates are unlikely to pose significant risks to banks. Starting with the verification of mortgage delinquency rates, real estate and banks have consistently been sensitive sectors within the U.S. financial system. However, apart from the collapses of Silicon Valley Bank and Credit Suisse at the beginning of 2023, we find that real estate enterprises remain stable in the current high-interest environment. Mortgage delinquency rates are lower than pre-pandemic levels, and the upward potential of housing prices will further reduce any MBS-related risks for banks.

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Mortgage delinquency rates have yet to reach pre-pandemic levels, and the cushion provided by accommodative policies persists. As of June 2023, the average delinquency rate for U.S. mortgages in the 30-to-89-day range stands at 1.2%, still well below the pre-pandemic rate of 2% (Figure 12), though with significant variation. It is important to note that higher housing costs in certain regions do not necessarily translate to higher delinquency rates. The affordability of housing depends on the ratio of regional income to housing prices. According to the National Mortgage Database, 22 out of 50 states currently have delinquency rates above the national average (Alabama, Arkansas, Connecticut, Delaware, Georgia, Indiana, Kentucky, Louisiana, Maine, Maryland, Mississippi, Missouri, New Mexico, North Carolina, Ohio, Oklahoma, Pennsylvania, South Carolina, Tennessee, Texas, West Virginia, Wyoming). However, most of these are states with consistently higher long-term delinquency rates, and the easing or tightening of policies has not altered the inertia of delinquency rates in these areas. Even in states with the highest increases in housing prices, such as California and New York, delinquency rates have slightly risen compared to the national average. However, due to higher regional incomes, they still remain at or below the national average. Therefore, we believe that mortgage default rates are unlikely to experience unexpected increases in the short term, and the risk exposure of MBS to banks is limited.

Residential Sector: Facing Structural Housing Shortages

Property prices indirectly impact residents' spending capabilities, manifesting as wealth effects influencing consumption expectations and mortgage rates affecting current spending limits. Wealthier households allocate a smaller proportion of their assets to residential properties, with a higher proportion allocated to various financial investments. This implies that the impact of a decline in housing prices has already been offset by the appreciation of other assets. Therefore, fluctuations in housing prices disproportionately affect middle and low-income families, as residential properties constitute over 50% of their wealth (Figure 13). A decrease in housing prices not only leads to a perceived decrease in their wealth but also a decline in consumption expectations. Currently, these residents can use home equity for short-term loans and consumption, but this capacity is also diminishing. Mortgage rates and the loan amounts accessible through Home Equity Loans directly impact residents' spending capabilities. The reduction in mortgage expenditure speaks volumes about its impact on monthly income. Home Equity Loans involve borrowing against the net value of a home, where net value is the market value of the property minus the remaining mortgage. When property values decline, net value also decreases, resulting in a reduction of accessible funds and a natural decrease in spending.

For instance, consider a property with a total value of $2 million and a remaining mortgage of $900,000, resulting in a net value of $1.1 million. Homebuyers can leverage this net value through various financial instruments such as Home Equity Loans, Home Equity Lines of Credit (HELOC), and Cash-out Refinancing for short-term consumption. Refinancing loans are prevalent, allowing U.S. households to access cheaper funds and extend repayment terms when their properties appreciate or interest rates decrease. This also enables homeowners to cash out a portion of the property's appreciation. Residents can even use second mortgages to repay credit card debt in advance when the property appreciates, as mortgage interest rates are typically lower than those of credit cards. The flexibility of the housing finance market positions residential mortgage debt as the fourth-largest debt category in the U.S. credit market, following federal government debt, financial sector debt, and business loans. Refinancing loans can account for up to 60% during periods of rising home prices or low interest rates. In Q3 2023, residents, facing apparent financial constraints compared to the previous two years, sought relief through refinancing, with a total HELOC amount of $349 billion, surpassing any single year between 2020 and 2022 (Table 3).

Amid soaring property prices, existing homeowners are hesitant to reduce prices for fear of diminishing the income they can use to upgrade to a new home. When assessing the impact of housing affordability on the demand side of the real estate market, the common metric involves comparing the ratio of income to property prices. However, due to income disparities among residents, using overall median income and median property prices for comparison lacks significance. In this context, we focus only on the middle and upper-income groups who have the capability to make down payments and secure loans. Traditionally, high prices encourage sellers to increase supply, dampening buyer demand, primarily leading to a shift in the demand curve resulting in price decreases. However, since 2022, the U.S. housing market has displayed a notable trend of rising prices despite decreasing transaction volumes (Figure 14), suggesting that supply factors play a more significant role in the current existing housing market. Combining this observation with a focus on the middle and upper-income groups, we can have a tentative conclusion: the affluent demographic, in the face of reduced housing demand, has resisted lowering prices on their existing homes, opting to maintain high property values to sustain their wealth and potential income.

This speculation suggests that the middle to high-income demographic perceives the cost of upgrading to a new home as higher than anticipated, leading them to resist lowering prices on their existing homes. To substantiate this viewpoint, we can estimate the additional cost a middle-class family would incur to upgrade to a new home using the common scenario of a 19% down payment and a 30-year mortgage with prevailing interest rates. Despite the mean income of residents continuing to increase, the median household income in the United States has only shown an 11.2% increase from 2020 to 2023, significantly lagging behind the simultaneous 169% increase in the annual interest payment amounts over the same period (Table 4).

The gradual convergence of new single-family home prices and existing single-family home prices allows us to boldly speculate that this point represents the median price affordable for the current homebuyer demographic. The 17.6% year-over-year decrease in new home prices (Figure 15), accommodating buyers, and the 3.4% year-over-year increase in existing home prices, aiming for profitability, highlight the evident budget constraints faced by the home-buying population. This suggests that, while there is substantial demand in the housing market, buyers are constrained by budget limitations, only able to reach a price point that existing homeowners are unwilling to sell below. This aligns with our earlier speculation.

Outlook: Housing Prices and Wages Pose Potential Inflation Risks

Last year, as the market observed the sluggish economic performance reflected in the U.S. Beige Book, coupled with consistently meeting expected inflation data, there was a growing anticipation of aggressive interest rate cuts in March of this year. At that time, we believed that even for achieving the soft-landing target, a rate cut in March would be premature. There are two primary reasons for this. First, the portion of the wage-inflation spiral that has yet to cool down is unlikely to decrease rapidly in the near future. Second, the slow adjustment in the mismatch between housing supply and demand is unlikely to produce miracles. To prevent it from causing re-inflation, the Federal Reserve is inclined towards adopting a "higher for longer" approach.

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The cooling of the wage-inflation spiral is expected to be lower than initially forecasted, with the descent rate potentially hinging on U.S. infrastructure policies. This perspective is derived from observations of the Nonfarm Payroll and Job Openings by Industry across different industries. Employment in the U.S. construction, wholesale retail, and healthcare sectors is on the rise, warranting separate examination of each. The uptick in the construction sector is comprehensible, given that two years have passed since President Biden's infrastructure plan was approved in November 2021. Recognizable railroads and airports like Amtrak, LAX, JFK, and DFW are undergoing varying degrees of renovation. Additionally, numerous infrastructures, such as water supply systems, public mobile communication stations, and new energy vehicle charging networks, are expanding and being updated, albeit not always visible through macro-level data. As for shortages in the wholesale retail and healthcare sectors, understanding which specific talents are lacking is crucial. A sudden shortage of supermarket managers or professional doctors may seem perplexing. In the case of healthcare, according to AAMC data, the U.S. indeed faces a shortage of physicians, but this is a long-term issue (10 years or more), with a stable and consistent shortfall. The increased frequency of sudden illnesses after the pandemic cannot adequately explain the significant surge in job vacancies in this industry post-pandemic. Positions with higher technical content or higher salaries are limited and do not require substantial growth unless there is an expansion trend in businesses. Therefore, we believe that these industries are most in need of hourly workers engaged in fundamental sales and services. In the U.S., 55% (approximately 76 million) of the wage-earning population falls under gig workers. By observing them based on education or income levels, it becomes apparent that, before 2020, the median wage increase for those with a high school education or below was lower than for those with a college education. However, starting from the end of 2020, this trend reversed until the growth rate in August-September 2023 once again dropped below that of the college-educated population. A similar trend is evident when examining wage level quartiles (Figure16), and this trend is even more pronounced:

It is worth noting that there are signs of an upward trajectory in wage growth for gig workers and grassroots service personnel (Figure 17). This is a consequence of the shortage of gig workers and basic-level service personnel, who are an indispensable part of completing various services, such as truck drivers, supermarket cashiers, hospital receptionists, etc. While they may experience wage cuts or job reductions due to high inflation, they are unlikely to disappear from the job market. With originally modest wages, companies find it challenging to attract workers after wage cuts, compelling them to raise wages once again. Therefore, the labor supply-demand structure of such workers makes us believe that there is an extremely resilient portion within the wage-inflation spiral that cannot smoothly lower as expected by the market. Regarding the statement that the beginning of this section mentions the wage spiral depending on U.S. infrastructure policy, it is because it is challenging to address the wage inflation in the service industry's gig workers. The labor demand in the infrastructure sector depends on whether the next president will continue to bolster infrastructure plans. With Ron DeSantis withdrawing from the race and fully supporting Trump, Biden faces a challenging re-election, making it unpredictable how policies will unfold after late 2024.

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Interestingly, before the publication of this article, two pieces of news gradually confirmed our judgment. In terms of the self-circulation between wages and consumer spending, the 2023 Q4 GDP report reveals an increase in consumer spending on goods and services and disposable personal income. Simultaneously, Biden announced a new batch of $49 billion infrastructure projects in Wisconsin on January 25th. The fiscal stimulus brought about by the U.S. elections this year is at odds with monetary policy. The seemingly plain infrastructure plan is often overlooked by U.S. investors. However, we believe it is crucial to closely monitor the additional amounts in the infrastructure plan, as it could lead to unexpectedly resilient wage growth and employment in industries such as manufacturing, construction, and mining.

Apart from this, we also believe that the structural mismatch in housing will continue to adjust at a slow pace. A significant number of homes in the United States were planned for families in the last century, primarily consisting of single-family residences. These homes are not suitable in terms of living space and price for the current trend of living alone or in groups of 2-3 people, mainly comprised of young individuals, while also severely lacking in supply for low-income individuals and families. To address such issues, apart from reducing the prices of existing homes, there is a need to rely on new home construction to improve the variety of housing supply. From the divergence between the trend of US New Home Sales and US Housing Starts Single Family at the end of 2023 in Figure 18, we can observe a rapid increase in demand for smaller and more cost-effective residences, contrasting with the overall decline in new home sales. Although there is a structural improvement in the diversity of new home supply, the overall quantity remains inadequate. Even with an increase, the construction speed is unlikely to yield miraculous results. Correspondingly, Single-Family Units Completed reached a peak of 1,102 units in November 2022 and has since declined to 960 units in November 2023. With companies deleveraging in 2023-24, the completion rate is expected to continue decreasing to around 900 units (Figure 18), similar to the pre-pandemic level. The visible slow adjustment in supply-demand mismatch continues.

If interest rate cuts are implemented, housing prices are unlikely to decline rapidly. Firstly, concerning new home supply, similar to 2021, we believe that the increase in demand will not lead to a rise in the completion rate of newly constructed homes. The time required to complete a house remains constant, and after an interest rate cut, we might once again see the difference between new home starts and the completion rate widening. During the period when interest rates are not low enough and existing home inventory is not fully released, housing prices are unlikely to significantly decrease, and they may even rise. Secondly, in existing home transactions, mortgage interest rates need to decrease significantly to potentially release existing inventory. However, the current official expected interest rate cut is 75 bps, while the market expects 100-150 bps (based on current 30-day interest rate futures pricing), which is still not enough to entice most people who borrowed at MBS rates of 3% to refinance. Therefore, we believe that even if interest rates fall and home sales volume increases in the next six months or more, housing prices in the United States will remain high, contributing to the risk of renewed inflation, and the duration of sustained high interest rates will be longer. From another perspective, Powell may not want to repeat the mistakes of Arthur Burns and could potentially delay the interest rate cut due to various factors, including the real estate market, contributing to renewed inflation. Expectations for housing prices and interest rate cuts influence each other.

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Finally, in the previous discussion, we briefly examined the resilience of two theoretically sensitive sectors: banks and real estate enterprises. We believe that in 2024 if there is a possibility of a continued rise in housing prices, both the banking and real estate sectors will continue to exhibit resilience in a high-interest-rate environment. In early 2024, the Federal Reserve may stop QT prematurely, and the rapid consumption of ON RRP has also accelerated this possibility. This implies the end of not renewing the expiration of $350 billion in MBS every month and a restart of purchases. A decrease in mortgage interest rates will inevitably stimulate demand, but we have studied the changes in housing prices from 2020 to 2023 as a reference to assess how much higher demand will drive housing prices.

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The timing of MBS liquidity injections has been closely synchronized with the surge in housing demand, propelling a rapid increase in housing prices. As depicted in Figure 19, there have been two peaks in housing prices across the United States. The first peak occurred in 2020, aligning closely with the time when the Federal Reserve increased MBS holdings. This surge can be attributed to the linear logic resulting from lowered mortgage interest rates and an increase in wage growth. During this period, there was a noticeable rise in new home transactions and starts, but the pace of new home construction (Units Completed) did not witness a miraculous change, showing little improvement in the expansion and efficiency of real estate developers. This discrepancy between demand and the actual increase in the supply of constructed homes during this period was a primary factor behind the first surge in housing prices.

The second surge in housing prices is attributed to the supply-demand mismatch we previously mentioned. During the pandemic, the prevalence of remote work and soaring housing prices in major cities prompted many individuals to relocate to rural areas in the South to reduce living costs. According to the U.S. Census Bureau, the Southern region experienced the largest population growth in 2023 at 1.1% (1.37 million people). Each region in the U.S. has land regulations, determining factors such as the number of houses that can be built, the distance between houses, and the overall population capacity of residential areas, which are defined by state governments. In the sparsely populated South, the construction primarily consists of multi-unit residences (apartments or condos). Despite the influx of population, it is highly improbable to reverse the demand for housing in major cities by young and middle-aged individuals, who constitute the primary home-buying demographic. Consequently, there is now an imbalance where major cities face inadequate supply while rural areas experience an excess supply of housing. This scenario has led to a situation where major cities suffer from a scarcity of supply and reluctance by existing homeowners to sell their homes at lower prices in response to buyers' demands. The strong sentiment of holding onto properties, coupled with reduced supply, has resulted in a situation where the decrease in supply is even more pronounced than the reduction in demand. The high prices and elevated mortgage interest rates in major cities further limit transactions in the resale market. In the face of suppressed demand due to high prices, homeowners in the resale market, which dominates the U.S. housing market as previously discussed, are unwilling to exchange their current homes for new ones or accommodate lower-priced sales. This strong reluctance to sell contributes to a reduction in supply, potentially leading to further increases in housing prices even before a substantial easing of quantitative tightening (QT). In either scenario, housing prices have fundamental support, and we believe that the banking and real estate sectors sensitive to higher interest rates can experience a safe landing this time.

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In conclusion, the timeline for interest rate cuts from a policy perspective may be later than the market expects, and we believe that interest rate cuts will not commence until at least Q3 2024. The resilient demand in the service and construction industries, coupled with the ongoing expansion of U.S. infrastructure plans and the domestic demand cycle supported by consumer spending, will provide robust support for the wage-inflation spiral. On the corporate side, we believe that real estate developers, who are most sensitive to interest rates, are operating healthily, and the normal rate of mortgage default rates will not pose systemic risks to banks. On the consumer side, the housing supply-demand mismatch and slow adjustment in supply suggest that even after interest rate cuts, rising demand may drive housing prices higher again, prompting the Federal Reserve to potentially slow down the pace of interest rate cuts due to the impact of housing prices on inflation. Therefore, we anticipate that the U.S. economy will remain resilient in 2024, largely discarding the possibility of a recession (although not ruling out as a tail risk event), focusing on the potential for a soft landing and re-inflation. Above all, we believe that the probability of re-inflation is larger than imagined by the market. In Appendix 1, we have compiled three distinct trigger events for re-inflation risks for reference.

JAPAN

The Importance of the Real Estate Sector to the Japanese Economy

The real estate sector is a crucial component of the Japanese economy. From the supply side, the real estate sector connects numerous upstream and downstream businesses, with the contribution of the Japanese construction industry to GDP averaging around 5.23% over the past decade. On the demand side, despite the backdrop of high urbanization and an aging population, the increase in household numbers and the stimulus of low-interest rates led to a rebound in Japanese property prices after the COVID-19 pandemic in 2020. Simultaneously, Japan's unique housing finance and main bank system, together with the real estate sector, constitute a critical link in maintaining the stability of the financial system. The bidirectional positive feedback between supply and demand in the real estate sector has resulted in an average contribution of around 12% to Japan's GDP over the past decade.

Looking back at history, after the end of World War II, the Japanese economy rapidly rose, and the urbanization rate continued to increase, driving property prices in Japan continuously upward. In 1991, Japan entered the "post-real estate era," with the urban land price index reaching a historical peak. It continued to decline for more than 20 years until the implementation of QQE (Quantitative and Qualitative Monetary Easing) in 2013, gradually stabilizing the real estate market. Stimulated by the long-term low-interest-rate policy, the Japanese real estate market experienced a slight rebound and entered a recovery phase after the COVID-19 pandemic in 2020. Based on data disclosed, after the clearance of the real estate bubble, Japan's real estate development is currently in a relatively rational and slow recovery phase in 2023. Starting from the importance of the real estate sector to economic development, we can understand current and future trends in the Japanese economy by observing the operational status of the real estate sector.

Policy: Breaking Free from the Deflation Quagmire

The Japanese economy experienced rapid growth after World War II, gradually surpassing the United States around the 1980s. However, after the bursting of the economic bubble in 1991, it entered the "Lost Two Decades." With the advent of Prime Minister Abe in 2013, Japan initiated large-scale quantitative easing and structural economic reforms, leading to a slow recovery of the Japanese economy. After March 2022, Japan gradually emerged from the impact of the pandemic, with the CPI turning positive, marking a gradual recovery.

Breaking free from the deflation quagmire, the Bank of Japan (BOJ) has signaled a shift in policy. With the combined influence of domestic and international forces, Japan's inflation continued to rise in 2023. By the end of the year, Japan's CPI had floated above the 2% inflation target. The core CPI, excluding food and energy components, experienced a slight decrease after reaching its peak in the summer (with November's core CPI at 3.8%, see Figure 20). Compared to previous years when the core CPI fluctuated around 0%, this significant improvement suggests that Japan may have successfully emerged from the deflation quagmire. In the context that CPI data has shown signs of improvement, BOJ twice guided YCC to more flexible operations in 2023, relaxing the range of purchasing ten-year Treasury bond yield limits. In December, Governor Kuroda stated that if the "wage-inflation" cycle strengthens and the prospects for consistently achieving the 2% inflation target improve significantly, the central bank might consider changing its monetary policy. We believe that this is a significant indicator of the BOJ signaling a shift in policy.

The prolonged low-interest-rate policy has made a positive contribution to stimulating the economy, especially in the context of improving inflation. BOJ Governor Haruhiko Kuroda attributes the factors driving the current rebound in inflation to two main forces: external and internal. From an external perspective, Japan, constrained by its limited land resources, heavily relies on imports. Since 2021, there has been a significant increase in import prices. Taking energy as an example, WTI crude oil experienced a phase of price increases in 2023 driven by various events such as OPEC control, the Israel-Palestine conflict, and the blockage of the Red Sea. However, the BOJ believes that the inflationary impact driven by the rise in raw material prices is temporary and cannot sustain inflation above the 2% target. Excluding external factors, the BOJ is committed to realizing a positive "wage-price" cycle. In 2023, during the "shunto" (spring labor negotiations), the rate of wage increases achieved its highest level in nearly 30 years based on the BOJ's own statistical data. The BOJ anticipates creating a sustainable positive cycle involving wage increases, companies raising prices, and an increase in inflation expectations for both businesses and households.

Business Sector: Operation Shows Sign of Recovery

Emerging from the economic bubble, the housing price index shows signs of recovery, with higher attractiveness in the Tokyo metropolitan area. Since actively addressing the real estate bubble in the previous cycle, Japan's residential price index had plummeted, reaching a bottom with a YoY change rate of around -28%. In 2013, with the implementation of "Abenomics," Japan's housing prices gradually stabilized. Observing the trend of the residential price index (January 2000 as the base, see Figure 21), Japan's residential price index has shown a noticeable upward trend since 2013, crossing the baseline after the pandemic and indicating a moderate recovery in the Japanese real estate market. The Tokyo metropolitan area price index, in particular, crossed the baseline around October 2018 and showed a greater upward trend than the comprehensive index in mid-2023, highlighting the unique allure of real estate in the capital region. According to statistics published by the Japan Real Estate Institute, the average selling price of new apartments in the Tokyo metropolitan area (Tokyo, Kanagawa, Saitama, Chiba) reached a high of 82.5 million yen, marking a year-on-year increase of 36.7% and setting a new historical high for the month of November.

Leading real estate enterprises see an increase in market share, signaling a mild recovery in business operations. Following the burst of the real estate bubble in 1991, industry reshuffling resulted in the exit of many small and medium-sized real estate companies. The industry consolidation preserved high-quality enterprises, leading to a YoY increase in market share for the top real estate enterprises. In 2020, the market share of the top 5 and top 10 real estate enterprises in Japan increased by 8.4% and 12.4%, respectively, compared to 2008, with the market concentration of the top 20 real estate enterprises reaching 58%. Taking the example of leading enterprises like Mitsui Fudosan, Mitsubishi Estate, and Sumitomo Realty & Development, since the fourth quarter of 2022, the QoQ revenue growth rates for real estate enterprises have generally rebounded (Figure 22). Among them, Sumitomo Realty & Development achieved positive growth in all three quarters of 2023, indicating a mild recovery in business operations.

The internal driving force behind the growth of leading real estate enterprises primarily comes from diversifying business operations and achieving dispersion within the conglomerate's internal industrial chain. Since the burst of the real estate bubble, leading real estate enterprises have transitioned from the traditional high-leverage development model to diversified business operations. Taking Sumitomo Realty & Development as an example, diversified business operations provide relatively stable positive cash flow, smoothing out cyclical fluctuations associated with a single business model. In terms of business composition, Sumitomo is primarily involved in property leasing, property sales, and construction, with revenue contributions of 45%, 23.6%, and 22.6%, respectively, as of the Q1 2023 announcement. Additionally, the internal industrial chain cross-collaboration within the conglomerate provides sustainable sources of funding for real estate enterprises. Taking the Sumitomo Group as an example, it encompasses a large number of businesses spanning various industries, including industrial, chemical, and financial sectors, with the Sumitomo Group Public Relations Committee covering 33 companies. The diversified and cross-linked industrial chain brings a continuous income source that can withstand economic cycles and act as a lifeline for real estate enterprises during challenging periods. Furthermore, extremely low policy interest rates and the main bank system have also supported real estate enterprises in overcoming challenges. The main bank system refers to the practice where a company typically maintains a close business relationship with one bank, and the bank holds shares in the form of creditors (usually accounting for 15-25% of its debt financing). The main bank provides various banking services to the real estate enterprise, and notably, even in financial distress, the main bank is expected to continue providing financing services to the company. For example, Mitsubishi UFJ Bank, formed through the merger of Sakura Bank from the Mitsubishi Group and Sumitomo Bank from the Sumitomo Group, illustrates how, combined with extremely low policy interest rates, Mitsubishi Estate and Sumitomo Realty & Development can benefit from lower financing costs through support from internal group banks. Looking at the trend in national land prices (Figure 23) disclosed by the Japan Real Estate Institute, the average land price for all purposes in Q3 2023 increased by 0.8% compared to the previous quarter. As land acquisition is an initial step in real estate development requiring significant capital, the rising trend in land prices suggests intense competition in land auctions. It is reasonable to anticipate that main banks facilitate financing for real estate enterprises in acquiring land capital. In summary, the mild recovery in the operational status of Japanese real estate enterprises in 2023 has made an excellent contribution to the growth of Japan's GDP and further propelled the country out of the deflation quagmire.

Residential Sector: Mild Rebound in Consumer Demand

Rising wages are supporting a moderate recovery in housing demand. According to the results of the 2023 spring wage negotiations released by the Japan Business Federation, the total wage increase rate, including regular pay, raises and basic salary growth, for large enterprises in 2023 is 3.91% (13,110 yen), marking the highest wage increase level in nearly 30 years since the data began to be recorded. Additionally, a survey of nearly 2,000 small businesses on "the existence of a pay raise system and the planned amount for this year" indicates that 76% of small and medium-sized enterprises have plans for pay raises. The increase in wages can to some extent support the moderate recovery of residents' housing demand. Higher savings rates and lower leverage are driving the resurgence of the real estate market. According to data from the Japan Statistics Bureau for households with two or more people in 2021, the average savings amount for Japanese households is 14.54 million yen, with a ratio to annual income (7.49 million yen) of 194.1%. On the other hand, the average debt amount per household is 8.56 million yen, accounting for 114.3% of annual income. The proportion of "housing and/or land" in household debt averages 7.91 million yen. 42.4% of worker households hold "housing and/or land debt." The higher savings rate confirms the purchasing power of residents, and the combination of low-interest rates with relatively low housing and/or land debt provides residents with the capacity to borrow for real estate purchases, further driving the recovery of the real estate market.

Stimulated by the global cycle of low-interest rates, there has been an influx of overseas investors. The yen has weakened under the influence of the negative interest rate policy, providing favorable loan conditions for overseas investors compared to many economies that are currently in an interest rate hiking cycle. According to a market survey report by JLL (Jones Lang LaSalle) on the Japanese market, foreign investors' real estate investments in Q1 2023 nearly doubled compared to a year ago, with a total investment amount of approximately 2 billion USD. Simultaneously, the robust rebound in Japan's tourism industry following the relaxation of restrictions post-pandemic has led to an increase in hotel investments. According to media reports, the Blackstone Group owns over one trillion yen in real estate in Japan, including investments in apartments, office buildings, and data centers. Singapore-based investment group QIP launched a fund in June with a total investment of 40 million USD, primarily targeting residential properties in major Japanese cities. The widespread influx of overseas investors has stimulated the development of the Japanese real estate market.

Outlook: Sustained Moderate Economic Recovery

From a policy perspective, we believe that a policy shift is more likely to occur in 2024, but it might be later than market expectations and is more likely to materialize in 2Q 2024. One of the focal points determining whether a policy shift will occur is the sustainability of the current inflation. As discussed earlier, the two forces driving the current inflation are the rise in raw material prices and the positive cycle of "wage-inflation." Verifying the sustainability of inflation primarily involves examining whether businesses can raise prices in the face of rising raw material costs and whether these price increases can be accepted by end consumers. In the first force, both manufacturing and non-manufacturing industries in Japan are implementing price hikes (Figure 24). Within manufacturing, industries such as food, textiles, and paper are experiencing relatively smooth price increases. In the non-manufacturing sector, industries like retail, hotel and catering, and wholesale are also implementing price increases. The extent of these price hikes confirms the strength of the first force in the current inflationary trend.

The realization of the "wage-inflation" positive cycle, which the BOJ is monitoring, depends on whether end consumers accept price increases. A research paper titled "Pass-Through of Cost-Push Pressures to Consumer Prices," released by the BOJ in November 2022, demonstrates through a study of price transmission that the cost-pass-through coefficient is relatively high in the current inflationary environment. This implies that businesses are more flexible in their pricing compared to the past (Figure 25). Companies that historically resisted price increases have raised product prices in response to the current inflationary pressures, confirming this observation over the past thirty years. Simultaneously, an active labor market is expected to drive continued wage growth. The BOJ report notes that companies immune to labor shortages over the past thirty years have reported labor shortages this year, confirming the vibrancy of the labor market. According to the annual employee turnover survey by Japanese recruiting company Mynavi, the resignation rate in 2022 was 7.6%, with the top reason for resignations being low salaries. An active labor market will continue to stimulate wage growth. In line with market consensus, we also anticipate a "spring wage adjustment" in 2024, which is expected to support the BOJ's exit from the negative interest rate policy.

From the perspective of businesses, the comprehensive impact of a policy shift on relatively healthy industries is relatively small. Although changes in interest rates will inevitably lead to an increase in financing costs, considering the healthy financial structure and profitability of real estate enterprises, a slight increase in financing costs is unlikely to have a significant impact on the real estate sector. Additionally, with the consideration of effective cost pass-through factors at this time, real estate enterprises may have the possibility of further raising property prices, resulting in a relatively minor overall impact from changes in interest rates.

From the perspective of residents, both the willingness and ability to consume are experiencing a moderate recovery, and the attractiveness of real estate remains high, particularly in overseas low-interest environments. Japan's unique social background will continue to drive growth in the number of households, leading to an increase in demand for real estate consumption. The potential vibrancy of the labor market will also continue to stimulate wage growth, providing assurance for residents' home-buying capabilities. Additionally, even in the event of a policy shift, Japan's status as a "low-interest haven" remains unchanged, maintaining its allure for overseas buyers.

We believe that the current inflation trend in Japan is sustainable, signaling the potential for the country to overcome deflation. We predict that the BOJ will undergo a policy shift in 2024, but it may not happen as swiftly as the market currently expects, possibly not until the results of the spring wage negotiations in 2024, with a more likely realization in Q2. The BOJ might enter an era of zero interest rates first and then consider infrequent and gradual interest rate hikes based on the inflation situation. While financing and construction costs for real estate developers may experience a slight increase with the policy shift, the relatively healthy state of the industry should ensure the normal operation of the real estate sector, minimizing the overall impact. The growth in the number of households has led to a recovery in residents' willingness to purchase real estate, and the expected wage growth provides assurance for residents' home-buying capabilities. In summary, we anticipate that Japan will undergo a policy shift in 2024. The overall situation of the real estate market is relatively healthy, and the real estate sector's contribution to economic growth will continue. The economy is expected to experience a moderate recovery.

APPENDIX 1: TRIGGERING EVENTS FOR RESURGENT INFLATION RISKS IN THE UNITED STATES

Uncontrollable Military Expenditure. Selecting the military as a focal point is strategic. In the historical context of high inflation in the United States, significant factors have been the monetization of war expenses and fiscal monetization resulting from government debt. Inflation often arises from urgent situations leading to uncontrollable borrowing and external shocks or internal turmoil causing domestic supply-demand imbalances. Presently, the United States must address the indirect tension in the supply chain due to reverse globalization and a presidential election influenced by the despair resulting from internal wealth disparities and exploitation gaps. Although there may not be a singular event in 2024 exposing the United States to re-inflation risk, it cannot be dismissed that military spending, coupled with increased supply chain costs, could lead to unforeseen consequences. Many macro-level consequences are often a collection of unforeseen events, making it challenging to plan for the overall trend. The continuity of supply chain disruptions is uncertain, but the ongoing expansion of the military budget is apparent. The U.S. defense budget and military expenditure, falling under discretionary spending, are annually approved by Congress and the sitting president. Typically, over half of the discretionary spending amount is allocated to the Department of Defense (DoD). The U.S. defense budget for 2023 was $813 billion, reaching $842 billion in 2024. Defense spending usually constitutes 12% of total expenditure, and we deduce that the total fiscal expenditure for 2024 may surpass the current market expectation of $6.6 trillion, reaching $7 trillion (Figure 26).

The diminishing debt cushion in the U.S. Treasury increases the risk of a compounding debt situation. Following the exhaustion of short-term debt issuance, there's a gradual shift toward long-term debt issuance. However, the current inverted government bond yield curve limits institutional investor interest in long-term bonds, including banks and pension funds. Formerly the largest holder of U.S. Treasury bonds, China has consistently reduced holdings, retaining only 60% from 2015, contributing to heightened borrowing costs for the U.S. With the current U.S. fiscal budget at $6.9 trillion, surpassing 2023 by $0.5 trillion, a potential return to power by the Republican Party, especially under Trump, may lead to tax-cutting measures reminiscent of the 2017 reform. This could further reduce fiscal revenue, primarily sourced from individual taxes, complicating U.S. efforts to navigate a debt cycle, with each step incurring higher costs than before.

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Anticipations of premature rate cuts have prompted a pause in corporate deleveraging. BoA's report reveals that an increasing number of companies are opting for a mild leverage-up after a period of trimming their balance sheets. By December 2023, the bank had already issued $23 billion in investment-grade corporate bonds. With the market relieved by the confirmation of no rate hikes, attention now shifts to speculation about when rate cuts will occur and expectations of a loose economic environment. The gradually decreasing effective interest rates on corporate bonds corroborate this sentiment (Figure 27). The January 2024 ADP figures, surpassing expectations, along with lower-than-anticipated initial jobless claims, offer additional confirmation of this trend.

APPENDIX 2: CHANGES IN HOUSEHOLD COMPOSITION IN JAPAN

Against the backdrop of population decline and aging, the increase in the number of households has generated new demand for home purchases. According to data released by the Statistics Bureau of the Ministry of Internal Affairs and Communications of Japan, the country entered a period of population decline in 2011, with the natural population growth rate reaching -0.15% in 2015 and continuing to decline annually (Figure 28). The proportion of the aging population reached 28.9% in 2021, and it is projected to continue rising, reaching 31.2% by 2030. Despite the demographic challenges of population decline and aging, the real estate sector has not seen a reduction in its contribution to GDP in recent years. This is attributed to the increase in the number of households, leading to new demand for home purchases. According to statistical data, as of 2020, Japan had a total of 55.7 million households, with the proportion of single-person households showing an upward trend (Figure 29). Additionally, the average size of Japanese households has decreased from over 5 people post-World War II to 2.2 people per household. While the increase in the number of households and the decrease in the average household size may not necessarily result in a multiplier effect on housing demand, we believe that it will inevitably bring about potential additional demand for home purchases.

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