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Inflation a tiger with no teeth? The case for another rate hike remains weak

​​Where oh where has inflation gone?

As quickly as inflation accelerated earlier this year it has just as quickly decelerated, seriously jeopardizing a potential third Fed rate hike. Data from both the consumer price index (CPI) and the producer price index (PPI) failed to support a case for a rate increase. The headline CPI grew slightly in July, bringing the year-over-year increase to 1.7 percent, up from the 1.6 percent year-over-year in June, and the headline rate remained below the Fed's 2 percent target rate for the third consecutive month. Meanwhile, the less volatile core CPI also increased 1.7 percent year-over-year, the fourth consecutive month the core rate remained below the Fed's target rate.  Data from final demand PPI, which has recently been running ahead of the CPI, slowed and converged toward CPI readings in July. Headline PPI grew by 1.9 percent year-over-year, falling below 2 percent for the first time since January. And core CPI increased 1.8 percent on a year-over-year basis, the weakest rate since March.

Accordingly, inflation data since the first quarter of this year suggests that the surge following the election was temporary. Although the decline in wireless services garnered most of the blame, other more durable forces (such as slowing rent growth) also played a role. In particular, owners' equivalent rent (OER) has been declining since December on a year-over-year basis. OER represents the price at which a homeowner believes they could rent their house if they weren't living in it. Because OER represents by far the largest weight in the CPI market basket, it has a large impact on overall inflation. ​


Can inflation be turned around?

With the largest CPI component trending downward, turning inflation around over the balance of the year will be difficult. What might cause such a change? If tightness in the labor market can finally translate into greater wage growth that could lead to stronger growth in discretionary income, consumer spending, and inflation. Additionally, the dollar has been depreciating during most of 2017. A weaker dollar makes imported goods and services more expensive which can push up inflation. And if oil prices can break above their trading range that could put pressure on inflation. How quickly those changes could occur remains an open question, putting 2017's potential last rate hike in jeopardy.

Is low inflation undermining the case for commercial real estate?

While the potential rate hike remains our first concern when discussing inflation, we reiterate that each individual hike of 25 basis points has little impact on the commercial real estate (CRE) market. A bigger question concerns CRE's role in the investment universe as an inflation hedge. Although CRE has always served as an imperfect hedge, it played this vital role for investors. Is that role diminished in a low-inflation world and, if so, does it undermine the case for owning commercial real estate? Certainly an inflation hedge matters less in a low inflation environment, but CRE serves other vital roles to investors. Its low correlation with other asset classes makes it a good diversifier of risk. 

And even in today's low cap rate environment, CRE offers attractive yield spreads relative to other income-producing assets.

CRE also offers a large investable universe as the third-largest asset class and diversity of opportunity because of the abundance and variety of individual properties. CRE's risk-adjusted performance, providing attractive total returns with lower volatility than many other investment classes, remains compelling. For many investors, especially many foreign investors, CRE simply represents a safe store of wealth. 

The investment thesis for CRE remains as solid as ever, even in a low-inflation environment.​

U.S. North Korea tension roils markets

The leaders of the U.S. and North Korea traded fiery barbs last week. While these had absolutely no impact on the real economy, they did trouble financial markets as the talk intensified. Nervous investors rotated out of risky assets such as equities into risk-averse assets like Treasuries, gold, the Japanese Yen, and the Swiss Franc. The S&P 500 Index fell roughly 1.43 percent last week, the second-worst weekly performance of the year. Meanwhile the CBOE Volatility Index (VIX), widely considered to be the best measure of fear in the stock market, posted its largest weekly increase since December 2015, reaching its highest level for the year. Tension eased over the weekend, but risk remains elevated.

Debt ceiling issue will be priority for legislators

Congress will return from recess on September 5th. When they return, the debt ceiling will be at the top of the agenda. The Treasury will be able to implement "extraordinary measures" to issue new debt once the ceiling has been reached, but this is a short leash. Treasury Secretary Mnuchin asked Congress to raise the debt limit by September 29th. The consequences of failing to raise the debt ceiling would be severe which is why we expect Congress to raise the debt ceiling.

What we are watching this week

Retail and housing will be our focus this week. ​Housing starts likely increased in July while building permits were likely little changed. Housing continues to slowly strengthen which should underpin the economy.

July retail sales, both headline and core, are both expected to have grown by modestly healthy rates after both declined in June. That would be a good sign for both the economy and retail real estate, though structural changes in spending behavior continue to put a damper on retail properties. ​

Thought of the week

The financial health of the American consumer appears to have recovered from the Great Recession. The average national FICO score is 700, slightly above its cyclical high in October 2006 before the financial crisis.




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