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​Economic activity points to further growth—slowdown not expected until 2019

Economic Outlook - Q2 2017

Faster growth in the latter half of the year should keep the economy on its current growth path in 2017. Given the potential for modest fiscal stimulus, we see somewhat stronger growth of 2.5 percent likely in 2018. We see a low probability of a recession over the next 12 to 18 months. The overall economic climate during the latter half of 2017 and 2018 should remain conducive to attractive real estate performance. Growth at this pace prevents harmful imbalances in the economy and financial markets (such as excessive debt or inflation) that could derail the expansion from building. In the absence of any random disturbances, CRE (across all major property types) should continue along its current, generally positive trajectory. That is not to say that we won't experience variations by property type and market. But any problems that the sector faces should come from internal sources, such as overbuilding, rather than external economic disturbances.

In the absence of a random shock, we believe that the current cycle should be able to challenge the record for the longest uninterrupted expansion in history, 10 years. That would occur in mid-2019. Economic expansions don't die of old age – something kills them off. The three usual suspects for ending expansions could present risks in 2019, which increases the probability of a recession. Interest rate increases should continue over the next two years, asset values could continue to increase potentially inflating a bubble, and though oil looks cheap now a sudden rise in energy prices can be difficult to predict. Any of those has the potential to derail the current expansion, but probably not until 2019 at the earliest.

What's contributing to this outlook?

​The economy is growing at a rate higher than expected

Economic growth in the second quarter of 2.6 percent on an annualized basis greatly exceeded the 1.2 percent annualized growth rate from the first quarter. It was also the strongest quarterly growth rate since the third quarter of 2016. Growth during the second quarter was broad, coming from improvements in consumer spending, corporate investment, and international trade. For the first half of the year, growth registered 1.9 percent, slightly behind the 2.1 percent average annual growth rate during the current expansion. 

We believe the economy can perform slightly better in the latter half of the year, but such a weak first quarter will limit growth for 2017 to roughly 2.2 percent. 


Despite meaningful wage growth, consumers are relying on savings and debt for purchases

Consumer spending for the first half of the year ultimately performed better than initial preliminary data indicated. But the ability of the U.S. consumer to spend remains somewhat limited despite a tight labor market. We anticipate that the unemployment rate will remain more or less unchanged for the balance of the year with job growth trending slightly down. Year-to-date job creation has averaged roughly 180,000 jobs per month. We forecast a slight slowing during the latter half of the year due to labor scarcity, but not much of a difference. During the prior 7 calendar years, average monthly job creation differed little between the first half and second half of each year.

Yet tightness in the labor market has not translated into more meaningful wage growth because of weak inflation and labor productivity growth. While a stronger labor market could push up wage growth in the latter half of the year, we do not anticipate that happening. As a result, consumers' ability to spend in a discretionary manner remains limited. That in turn limits economic growth because consumers still represent roughly two-thirds of the economy. Nonetheless, consumers are playing their part as well as they can by relying on savings on debt. The savings rate fell to 3.8 percent in June, its lowest level since before the recession. Meanwhile, total credit card balances grew to $784 billion in the second quarter, the highest level since late 2009. These trends are not sustainable so they call into question the durability of consumer spending without wage increases. Despite these limitations, consumption should grow by about 2.5 percent in 2017. Certainly, targeted income tax cuts could boost consumer spending, but there remains little chance of that for 2017. We still believe that is a more likely scenario for 2018.

Corporate investment is rebounding

Business investment has improved in 2017 due to a confluence of favorable developments. Increasing business optimism in the wake of the presidential election, a stronger global economic outlook, and a resurgent energy industry all drove investment in the first half of 2017. Leading indicators suggest that the outlook for the balance of the year remains optimistic. The ISM new orders index has been trending upward in recent months and indicates that investment should continue. But we do not expect an acceleration relative to the first half of the year. For all of 2017, fixed investment growth should be about level with the growth rate from 2015, about 3.5 percent. That would represent a significant rebound from 2016's weak investment increase and could potentially improve productivity growth in the future.

Government spending and fiscal policy will be spread out over a number of year

Government spending should change very little in 2017. We continue to believe that a modest fiscal stimulus package can be approved by Congress. However, because so many other items (like the debt ceiling deadline) remain on the legislative agenda at this late point in the year, any stimulus package will likely be enacted in 2018 and its impact will be spread out over a number of years. Tax reform and cuts offer an even more mixed picture. Given the difficulty that Congress faced when trying to pass healthcare reform, there is no reason to think that tax reform will be any easier, and if anything will likely prove even more difficult to enact. Tax law is full of loopholes that will be ardently defended by special interests and there is little chance of consensus being met on such issues. Simple temporary tax cuts are far more likely than tax reform. But given the timing, there should be virtually no impact on the economy in 2017, even if tax cuts are passed this year. We see a better chance for fiscal policy to impact economic growth in 2018.

Monetary policy and interest rates have been tempered

In the absence of faster inflation, the Fed will not raise rates again this year. While a tight labor market and higher import prices (thanks to a weakening dollar) could help, they are unlikely to be sufficient. Therefore, we expect the target fed funds rate to remain in the 100 to 125 basis point range, with an average effective funds rate of approximately 116 basis points. The Fed will likely commence balance sheet normalization (selling Treasury and mortgage instruments to reduce their asset base) in the fourth quarter. Depending upon how quickly this occurs in practice, selling these assets could put upward pressure on the long end of the yield curve if prices fall, even without another rate hike. Consequently, we believe that the ten-year Treasury rate will end the year in the 2.0 percent to 2.5 percent range with the impact of asset sales adding to uncertainty. That would steepen the yield curve which has been flattening in recent months.  Potential fiscal stimulus will likely serve as the main driver of short-term rate increases beyond 2017. Additional spending and tax cuts could temporarily boost economic growth and inflation, giving the Fed the cover it needs to continue raising rates. We see roughly two rate hikes in 2018, provided that there is some fiscal stimulus implemented.


Risks

The outlook remains fraught with risks, particularly on the policy side. Though the rhetoric has been toned down a bit, geopolitical tension has been amped up in recent weeks. Foreign policy could upset the apple cart if cooler heads do not prevail. International trade is likely to remain neutral for economic growth in the latter half of the year, but that assumes no counterproductive measures (such as new tariffs) from the administration. Restrictive immigration could produce a drag on the labor market and the overall economy. Financial markets have experienced low volatility while continuing to rise. A correction or more serious pullback could upset the real economy if it affects spending. 




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