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Souring retail sales

​Despite soft retail sales, inflationary pressures build

Retail sales for January fell short of expectations. Headline retail sales contracted, resulting in its worst showing in almost a year. Core retail sales (also known as control group retail sales) also failed to meet expectations with no change during the month. Although a rather weak start to the year, we would not conclude too much from this data, even if it ends up dampening growth in the first quarter. Consumer sentiment recovered some lost ground in February and rose to its highest level since October 2017. And the impact of tax cuts will not be felt by most consumers until this month while wages should continue to grow as the year progresses.

Despite soft retail sales, inflationary pressures continued to build in January. The headline consumer price index (CPI) exceeded expectations, largely due to a rise in gasoline prices. On a year-over-year basis, headline CPI remained unchanged at 2.1 percent. Meanwhile, core CPI also surprised on the upside, holding the year-over-year growth rate at 1.8 percent. A significant surprise in apparel pricing, the strongest monthly gain since February 1990, drove the core CPI. Although such a strong gain in apparel pricing likely cannot be sustained, it highlights an important development – rebounding retailer strength. Many retailers experienced a relatively strong holiday shopping season, leaving them with lean inventory levels. Because of this, they did not hold flash sales or offer discounts as sometimes occurs at the start of a calendar year. Also, a recovery among upscale retailers, which typically sell goods at higher prices, also pushed the overall price level upward. Retailers such as Canada Goose, Moncler, Coach, and Michael Kors have recently been performing well.

Consumers should have the wind in their sales in 2018 and retailers
will try to price accordingly, even if such strong increases cannot be maintained.

Meanwhile, the producer price index (PPI) for January displayed continued upward pressure on pricing. The headline increase matched expectations, but the core increase exceeded expectations.  On a year-over-year basis headline PPI accelerated to 2.7 percent while core PPI headed up to 2.5 percent. In recent years, upward pressure on producer prices had not filtered through to consumer prices. But that could be changing. Continued upward pressure on pricing can erode margins. If producers believe that consumers can digest larger price increases then they will pass them along. We do not think that recent pricing pressures signal a rapid acceleration in inflation this year. But these pressures are occurring before the impact from tax cuts hits consumers and business. We expect wages to continue to slowly rise, nudging above 3 percent. Such increases, coupled with lower tax rates, should provide consumers with the ability to keep spending which should put continued upward pressure on pricing.

Despite headwinds, housing continues to rebound

Housing data for January showed that the trend remains upward, if somewhat unpredictable. Starts jumped by 10 percent on an annualized basis. Multifamily drove most of the increase. Permits increased by 7 percent on an annualized basis with single-family permits declining slightly while multifamily permits surged by 27 percent. Single-family housing remains challenged by low inventories and high prices, so continued construction is heartening. More curious are the increases in starts and permits in the multifamily sector. Multifamily construction has maintained elevated levels for the last few years, despite slowing net absorption. Vacancy has ticked up during that time while rent growth has decelerated. In recent periods, asking rents have been growing faster than effective rents which means the return of concessions by landlords. Although these concessions remain modest, they reflect a competitive landscape due to new construction.

A number of markets (noteworthy among these New York and Washington, DC)
are starting
to look a bit overbuilt, particularly the class A segment. 

High construction and land costs typically render only class A product economically feasible for development. Recent housing data could indicate that the construction wave has not yet crested.

Not all government policies are helpful

The government failed to advance immigration policy legislation last week despite three different proposals for the "Dreamers" covered under DACA. The administration has threatened to stop renewing permits for DACA beneficiaries after March 5. If the policy were ended roughly 1.8 million people, many of which are working, would be forced to leave the U.S. That could hold serious negative consequences for a labor market that struggles to fill positions with qualified workers.

Meanwhile, the administration produced its budget last week. The overall budget appears to be a non-starter that Congress will likely ignore and the long-awaited infrastructure plan seemed underwhelming. While the budget included $200 billion for new infrastructure spending this would be offset by roughly $200 billion in cuts to current infrastructure programs. Additionally, the $200 billion allocation includes $100 billion (capped at 20 percent) for matching funds for state and local governments based on their ability to generate new revenue sources such as taxes, private capital, etc. Stronger economic areas might generate sufficient revenues to qualify, but many weaker ones would not, potentially ignoring areas that could benefit the most. And the allocated matching funds amount might not appeal to many state and local governments. Typically, the federal government matches at least 50 percent of the funds for large infrastructure projects such as the new Tappan Zee Bridge over the Hudson River in New York. Capping at 20 percent leaves far more funding that would have to be met locally – many financially strapped states and municipalities might balk at this. Congress will now start debating infrastructure spending. Committees will need to determine any plan, how to pay for it, and bipartisan support will be needed to pass any bill.

What it means for CRE

We will closely watch inflation as the year progresses. Accelerating inflation will likely put continued upward pressure on bond yields across the entire curve. We are currently predicting three rate hikes of 25 basis points by the Fed this year, but that could change if inflation builds faster than we anticipate. And the bond market has already demonstrated its willingness to sell off as inflation heats up. Rising rates will continue to gradually exert restraint on the economy, CRE fundamentals, and CRE pricing and volumes, even though we do not see much risk of that this year. The failure to reach a solution on the "Dreamers" could deport a significant number of people who are positively contributing to the economy. That would hold modest, but negative consequences for demand for virtually all major property types. Office has already experienced declining net absorption over the last couple of years due to a slowdown in net job creation. Multifamily vacancy rates have been rising for a few years as supply exceeds demand. Retail, still in the midst of a modest recovery, would not welcome the effective elimination of millions of consumers. 

What we are watching this week

Existing home sales for January should hold steady following December's decline. Initial unemployment claims should remain low amidst a tight labor market that continues to struggle to find qualified workers for many open but unfilled positions.​

Thought of the week

The Congressional Budget Office estimates the level of U.S. debt to gross domestic product (GDP) is currently around 77 percent. Given the recent fiscal policy measures, this ratio could rise to 85 percent by 2021.

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