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Stop us if you've heard this one before

Doesn't this sound familiar? Once again, the good news in the economy was tempered by bad news in the economy. In the tug of war between positive and negative news, neither side is clearly winning at this point, though much of the negative news seems to come from self-inflicted wounds. On the positive side, the employment situation continued to show solid job gains, with net employment increasing by 213,000. Revisions to previously months contributed a small net increase. Yet the economy is still struggling to fill jobs. The number of open positions in May declined to roughly 6.6 million, down from the record 6.8 million in April. The unemployment rate ticked up to 4 percent, but this was driven by an increase in the labor participation rate to 62.9 percent. The unemployment rate will require close watching over the coming months. Since World War II, once the unemployment rate hits its low for the cycle, a recession follows roughly a year later. Have we reached that cyclical low? Only time will tell, but if we see the unemployment rate gyrating without clearly heading lower again, that could be a sign of trouble.

Wage growth held steady at 2.7 percent on a year-over-year basis, somewhat modest for a labor market this strong. Other measures of compensation gains are showing stronger performance and with the number of people quitting their jobs reaching an all-time high, optimism for future wage growth is increasing. But one note of caution shows through in the compensation data. When we examine weekly earnings at the state level, using the most recent data available, we see that only about 10 states are generating wage gains stronger than the average on a year-over-year basis. And among these only a handful of states possess populations large enough to drive wage growth:

California, New York, Washington, Oregon, Massachusetts, and Colorado are all experiencing wage growth, as are Wyoming, West Virginia and Idaho. For virtually every other state, weekly wage increases are coming below the national average.

The shot heard round the world?

The first shot was fired in the escalating U.S.-China trade war last week. The U.S. government imposed a tariff of 25 percent on $34 billion of Chinese imports, the first round of the $50 billion of imports that the administration designated for tariffs. The Chinese government retaliated in kind, with tariffs of an equivalent magnitude on an equivalent number (though different kinds) of goods. The U.S. government chose to target intermediate and capital goods to lessen the impact on inflation and U.S. consumers. But these goods are used downstream by U.S. manufacturers and the tariffs will likely cause disruptions to their operations.

We anticipate minimal damage from the tariffs implemented thus far, roughly 10 basis points' drag on economic growth this year. But the tariffs should act like a supply shock – raising prices and lowering output. The key question remains how far down the rabbit hole the trade war goes.

If tariffs are implemented on the volume of goods that Trump administration
has mentioned (roughly $200 billion) and the Chinese government responds in
kind once again, that could have the ability to wipe about roughly 50 basis
 points of economic growth over the next 12-18 months. 

This would effectively offset the stimulus to the economy from the tax cuts and spending increases that have been passed since December. We also see little impact on inflation from the measures implemented, but they will push up prices at a time when inflation (including import prices) is already rising and should continue to rise.

Fed minutes signal more tightening to come

The Fed minutes from the June 12-13 meeting were released last week. Taken with recent statements from various senior Fed officials, the tone has turned more hawkish as we anticipated. The Fed appears less tolerant of inflation on the upside than when inflation remained stubbornly subdued. Some thought that because the Fed remained so accommodating given such tame inflation that it might show similar restraint when inflation rises above its target. But that hope does not seem that it will be realized. The minutes stated that based on the strength the Fed is seeing in the economy that it would keep raising the fed funds rate gradually until it reached a level "at or above" the long-run neutral rate. The danger lies in the fact that the neutral rate exists, but remains elusive if not unknowable. If the Fed pushes too far past the neutral rate it risks causing a recession.

We continue to forecast one more rate hike this year until
we know exactly how the trade situation will unfold.

If trade disruptions end with the measures implemented thus far, then two rates will likely occur. But if trade tensions escalate, they might stay the Fed's hand late in the year.

Implications for CRE

For commercial real estate (CRE), last week's events paint a muddled picture. The labor market data continues to be a positive driver for CRE. More jobs and higher wages mean more demand for all types of space, particularly office space. But the tariffs are unequivocally negative, even if their impact thus far remains limited. If the trade tensions continue to escalate, the fallout will become greater, particularly for the industrial market. And higher interest rates will eventually exert upward pressure on cap rates and downward pressure on valuations. Outside of industrial, fundamentals in the space market are slowly beginning to deteriorate. In time, cap rates will rise and valuations will decline. 

What else happened last week

The survey-based indicators continued to head higher. Both manufacturing and non-manufacturing ISM indexes increased in June, with optimism abundant. The only blemishes surround inputs, which show that the economy is becoming more capacity-constrained as it continues to expand – another sign that inflation should head higher in future months. The trade balance continued to narrow in June, despite a somewhat stronger dollar, with exports growing faster than imports.

What we are watching this week

Inflation data will abound this week – the producer price index (PPI), consumer price index (CPI), and import price data will be released. All are expected to show continued upward increases on a year-over-year basis, reaffirming our position in gradual upward pressure. As long as these trends persist, which we expect, the Fed should have enough fodder to keep raising rates above their neutral rate estimate.

Thought of the week

Across most major cities, including New York, Washington, DC, and Los Angeles, the use of public transportation is declining.

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