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Look to the Labor Market

​Strengthening labor market

Though slightly disappointing, the employment situation for December showed that the labor market remains strong heading into 2018. Disappointment arose because only 148,000 net new jobs were created, below expectations of close to 200,000 jobs. Strong performance in October and November, coupled with other firm economic data, pushed expectations for December upward. But in the overall picture, this slight miss does not alter the longer-term view that the labor market continues to tighten. Almost all of the other components of the report signaled continued improvement. The labor force participation rate continued to quietly drift higher while the unemployment rate continued to quietly decline, a sure sign that the labor market is absorbing workers returning from the sidelines. And due to the demographics – the U.S. has an aging labor force – the modest uptick in the participation rate understates the strength in the market. The participation rate of women has been driving the increase while the participation rate for men remains largely unchanged over the last few years.

Can the labor market drive inflation?

Wages grew by 2.5 percent year-over-year in December. Although alternative measures of wages have shown stronger increases than what the employment report has shown, growth nonetheless remains a bit modest. If inflation ramps up this year, the labor market will likely have to drive that acceleration. Continued declines in the employment rate should occur and could finally pass the inflection point where more meaningful wage growth and inflation materialize. Both have started to trend up in recent periods so a tighter labor market could be the catalyst for faster growth that many have been waiting for, particularly with the stimulus from tax cuts set to kick in this year. Increasingly, investors believe that tax reform will spur growth and inflation. The 10-year inflation break-even rate, calculated as the difference between 10-year U.S. Treasury note and the 10-year Treasury inflation-protected security, edged above 2 percent last week for the first time in roughly nine months.

The minutes of the December Fed meeting presented a view of the economy that largely agrees with our own – the economy remains firm and tax cuts will provide a shot in the arm, boosting GDP growth this year. The Fed also believes that wage growth will continue to accelerate and that last year's slowdown in inflation was temporary. Like us, they will be carefully looking for signs that ongoing tightening in the labor market could be tipping the economy toward faster wage and inflation pressures. 

We and the Fed are both anticipating three rate hikes in 2018 with the first of the three likely to occur at the meeting in March. 

ISM indexes still signaling expansion

The ISM manufacturing index increased during December, rising to a level that signals a robust expansion and remaining near its cyclical high. Meanwhile, the ISM non-manufacturing index declined slightly in December to its lowest reading in four months. Despite this pullback, the index remains at an elevated level. Taken together, although they show a pullback in December, they still reflect a continued, widespread economic expansion and appear at a level that supports our outlook for economic growth in the 2.7 percent to 2.9 percent range for 2018.

What does it mean for CRE?

For commercial real estate (CRE), the data from last week reaffirms our view that the economic environment should support CRE in 2018. Stronger economic growth and a tighter labor market would provide firm footing. We see two key challenges from the economic data. First, as we anticipated, the number of net new jobs continued to decline in 2017, the third straight year of declines. Even with a modest boost from tax cuts, we expect that trend to continue in 2018. That will present challenges to an office market that is already grappling with rising vacancy and escalating new construction. And new construction, both residential and commercial, will remain checked by a tight labor market. Second, three more rate hikes, faster economic growth and inflation, and the Fed's continued unwinding of its balance sheet should put more pressure on the long end of the yield curve, which remained largely unchanged over the last year. Over time, that could increase the cost of capital for CRE. Although that could slow new construction, which would be good for CRE fundamentals, it could also limit transaction volume and loan origination. 

What we are watching this week

Retail sales and inflation will be our focus this week. Headline and core retail sales for December should show relatively strong growth thanks to holiday shopping. Inflation, measured by both the producer price index (PPI) and consumer price index (CPI) should show slight decelerations in November. But the trend over time continues upward—particularly for the PPI, which probably grew at its fastest annual rate in six years in 2017. Data released last week from the Purchasing Managers' Index (PMI) indicated that manufacturers faced pricing pressure, which could be the first sign of resurgent inflation. We will see if the PPI data this week confirms that view.

Thought of the week

The relationship between the size of a firm and the wages a firm pays is breaking down. Historically, larger firms paid a wage premium. But that premium, which was once substantial, has been declining over the last 40 years. 

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