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Trade tensions threaten robust economic outlook

Once again, trade policy took the spotlight away from other important economic news last week. Last week the Trump administration announced that it would impose tariffs of 25 percent on an additional $50 billion worth of Chinese goods. The initial tariffs will go into effect on July 6. China retaliated in kind, which was largely expected. But the trouble does not stop there. The administration is currently considering tariffs on another $200 billion worth of Chinese imports to the U.S.

The combined impact of these tariffs plus the administration's tariffs on steel and aluminum
imports could reduce U.S economic growth by up to 50 basis points over the next 12-18
months, which would threaten to offset many of the benefits from the fiscal stimulus. 

Beyond this direct impact, the trade tensions could also potentially create secondary impacts if the negative feelings surrounding trade tensions begin to impact consumer and corporate behavior.

Economy firing on all cylinders in the second quarter

Trade aside, the data from last week signaled that the economy is heading for strong growth in the second quarter. Consumers have clearly moved past any weakness earlier in the year, spending strongly in May. Headline and core retail sales continued to exceed expectations, with headline sales growing at its fastest pace in about two years. Preliminary consumer sentiment in June increased versus the final reading from May, demonstrating the optimism felt by consumers due to tax cuts and a very tight labor market. Consumer spending will drive growth in the middle of this year above the long-run growth rate.

Although the economy cannot sustain this breakneck pace in the long run, in the short run, such strong growth should further contribute to inflationary pressures. May's readings for the consumer price index (CPI) and producer price index (PPI) showed meaningful acceleration in year-over-year price increases. The headline and core CPI increased as expected with headline CPI heading toward 3 percent while core CPI pushed further above 2 percent. Meanwhile the headline and core PPI rebounded from April, with the year-over-year change in headline PPI reaching its fastest pace of growth in roughly six-and-a-half years. Transport and freight prices (continually spotlighted by the media) continue to drive the PPI higher. Finally, import prices also headed higher, largely driven by higher energy prices, not tariffs. Although the tariffs could feed into import prices, they are not driving import inflation yet.

Fed raises, signals more hawkish forecast          

As we expected, the Fed raised rates by 25 basis points last week, the seventh time since the current tightening cycle began in December 2015. That hike brought the target rate up to 175-200 basis points. The  outlook for the macroeconomy is more positive and the Fed dropped the main part of its forward guidance though that does not come as a surprise. The Fed's median forecast now calls for four rate hikes this year (recall that the forecast fell just one vote shy of four at the last meeting). One vote pushed the forecast from three to four rate hikes this year, though the margin remains thin. We are not yet adjusting our forecast for the Fed funds rates upward. We would like to see the underlying wage and price pressures continue throughout the summer before making our adjustment.

We do not think that a fourth rate hike would be a mistake, nor do we think that the
extra hike would have a huge impact on the economy in the short run.

But downside risks, such as trade policy, are growing and their precise impact remains uncertain. The futures market shares our caution – only pricing in a roughly 50 percent chance of four rate hikes this year.

What it means for CRE

The strong economic data portends a relatively healthy commercial real estate (CRE) market this year. Accelerating economic growth should support leasing activity and, to a lesser extent, construction activity. Capital markets should also benefit. Transaction volume in the first half of the year has rebounded a bit. That trend could persist in the middle of the year, even though the trend over time remains downward. Refinancing activity could get a boost, particularly with many lending institutions loosening their underwriting standards amidst a highly competitive environment. We do not see a meaningful difference between three or four rate hikes for CRE this year. Although transaction volumes have declined, cap rates remain near cyclical low level and should remain there until the improvement in the economy and CRE fundamentals falters. Only then will rising interesting rates exert upward pressure on cap rates.

What we are watching this week

Housing will dominate the data releases this week, with housing starts, building permits, and existing home sales. Housing starts for May should rise slightly while building permits for May should not change much. We expect that existing home sales for May have increased marginally as well, heading back near the level from March after a decline in April. Existing sales are held back by limited inventory.

Though not an explicit data release, risks from outside the U.S. continue to materialize and increasingly demand attention.

Trade tensions are ratcheting up, global economic growth appears to be slowing, and central
banks around the world could put pressure on the economy at a time of record global debt. 

We continue to closely monitor these events and will update as appropriate. 

Thought of the week

Even after accounting for home equity, renter households have lower net worth than homeowner households across the age spectrum.

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