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1Q 2018 Economic Outlook

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Growth should test post-recession high in 2018

The economy grew by 2.3 percent at an annualized rate in the first quarter. Although growth slowed from the 2.9 percent annualized rate in the fourth quarter of 2017, growth exceeded both expectations and the performance of most first quarters during the current expansion. We highlight this development because growth has hasn't fared well in recent first quarters due to seasonal weakness based on the time of the year. Growth has averaged just 1.2 percent at an annualized rate in the first quarters of the current expansion, far slower than the 2.5 percent annualized growth from all other quarters. Growth in the first quarter was driven primarily by surprises in net exports and business investments. Consumption numbers did disappointed, though looked stronger toward the end of the quarter. We predict economic growth in the middle quarters of 2018 will accelerate due to fiscal policy stimulus like tax cuts. We are revising our growth projection for 2018 up slightly to 2.8 percent annualized, which should challenge 2015's 2.9 percent growth rate for the high watermark during the current expansion.

Commercial real estate (CRE) should continue to benefit from this resurgent growth. In a number of property sectors, the vacancy rate has increased in recent periods with new construction exceeding net absorption. Unsparingly, rent growth has slowed in these sectors. Rebounding economic growth should provide some underpinning for net absorption, even at this relatively late stage of the property market cycle. That should not completely offset the impact from rising construction levels, but because construction remains relatively disciplined, market fundamentals should benefit at the margin. For CRE capital markets, any improvement in fundamentals, even marginal, should support pricing and cap rates. As we have previously noted, cap rate compression for a number of property types has largely ended. Still-strong fundamentals and a diminished risk premium are holding down cap rates in the face of rising interest rates. But that won't last forever so even marginal improvements in fundamentals will delay increases in cap rates. Despite high prices and low cap rates, resurgent growth (or at least anticipation of it) could already be propping up transaction volume. Volume in the first quarter grew by 4.7 percent versus the same quarter last year. Although we still anticipate that volume will decline year-over-year for all of 2018, stimulus-fueled economic growth should make volume decline smaller than would have otherwise occurred in the absence of such growth.

We remain concerned about the relationship between the stimulus and ultimately slower growth and CRE market performance. While the stimulus should boost growth it should also likely fuel an already hot labor market. Wage growth was already accelerating before the impact of the stimulus measures. Accelerating wages could feed into inflation, which was also accelerating pre-stimulus. These were combining to push up interest rates, which across the yield curve are hitting their highest levels in years as the curve continues to flatten. Higher interest rates correlate well with slower economic growth which would ultimately translate into poorer CRE market performance for both fundamentals and capital markets. We see little risk of that in 2018 and even 2019, but these forces will continue to build over time.

Watch the trends

Even before the impact of the stimulus was felt, economic growth was accelerating, propelling tightness in the labor market, inflation, and rising interest rates. Stimulus will push on them even harder. Recently, the unemployment rate fell to 3.9 percent, its lowest level since 2000. Even the U-6 underemployment rate, a broader measure of labor market slack, reached its lowest level since 2001. This is occurring despite a general slowdown in job creation. Net employment gains peaked in 2014 and have been declining since. Job gains thus far in 2018 are slightly ahead of 2017's pace, but outsized gains in February look like an outlier. For the other three months, job gains averaged roughly 158,000 net new jobs and are remarkably consistent, falling in the 135,000 to 176,000 range. We caution that these figures are volatile, and job growth could present some upside surprise due to stimulus. But labor scarcity continues to intensify which should present challenges for job creation.  Declining unemployment rates and slowing job gains typify a tight labor market. The outlier remains wage growth. As we have mentioned in the past, wages in the long-run are primarily determined by inflation and productivity growth. Viewed through this lens, wage gains look appropriate. But in the short run a very tight labor market can distort that relationship and produce stronger wage gains. In recent periods, that has been occurring. Average hourly earnings grew by 2.6 percent in recent months, an increase over the last few years, but not a dramatic increase. The more comprehensive employment cost index (ECI) is showing a bit more acceleration, growing by 2.9 percent year-over-year in the first quarter. Should the labor market continue to tighten as we expect, with the unemployment rate falling toward 3.5 percent, wage growth should accelerate near 3 percent. 

While wages have slowly accelerated, inflation also ramped up ahead of any boost from fiscal stimulus. Across a variety of measures, such as the consumer price index (CPI) and the personal consumption expenditures (PCE) index, inflation is ramping up. A rebounding economy, creating demand for inputs such as labor, pushed prices higher at a quickening pace. Headline inflation now sits slightly above the Fed's target rate of 2 percent while core inflation is lurking at or near the target rate.

As fiscal stimulus fully kicks in during the second and third quarters, we
anticipate that inflation will continue to trend up, fueled by both the
stimulus and the underlying tightening in the labor market. 

This acceleration is becoming increasingly evident as the economy moves past transitory weakness in prices from the first half of 2017. Accordingly, we forecast that inflation will continue to head upward in 2018, with headline inflation settling into the mid-2-percent range and core inflation settling into the low-2-percent range.

Rates rise and yield curve flattens

Much like wage growth and inflation, interest rates also headed upward in advance of the impact from fiscal stimulus. Across the yield curve, from the fed funds rate to the 30-year Treasury yield, interest rates are hitting highs unseen for a number of years. While some of this stems from anticipation of the stimulus' impact, some of it undoubtedly stems from rising wages and inflation that has already occurred. Wage growth and inflation should push yields even higher in 2018. At the short end of the curve, we anticipate two more rate hikes this year in June and September.

We are keeping another rate hike in December squarely
on the table though the futures market and the Fed itself is not yet calling for it. 

At the long end of the curve, the 10-year Treasury rate should settle in above 3 percent by the end of the year. The empirical relationship between higher interest rates and slower economic growth remains intact.

As rates continue to rise, the yield curve should continue to flatten. Short rates should continue rise faster than long rates (which typically occurs during economic expansions) until eventually the yield curve inverts. Inversion (particularly the spread between 10-year and 2-year Treasury yields) remains the best predictor of recessions, which usually occur 6-18 months later. We do not forecast inversion this year, but we do not anticipate the 10-year rising much above 3.5 percent in the medium term because the long yield represents the future short yield. The Fed's long run target for the fed funds rate stands at 3.4 percent and the yield curve should continue to flatten as the fed funds rate approaches that target.

Risks and closing thoughts

We remain optimistic about the economy in 2018 and into 2019. But CRE market participants should keep a close eye on sentiment in the economy. Sentiment correlates well with economic growth, but in recent periods sentiment has pulled back slightly. Fallout from saber rattling over trade contributed to some of this decline and escalating trade protectionism would present an unambiguous negative for the economy and CRE market. But if sentiment continues to trend downward, regardless of the cause, we would take that as a warning about future prospects. We will continue to keep a close watch on the relationship between faster wage growth, stronger inflation, higher interest rates, and slower economic growth. That transmission often takes time to fully materialize and we see little risk of that occurring this year. But it is important to keep in mind that the expansion in the economy recently became the second-longest in history at 106 months.

Expansions do not simply die of old age, they are killed, usually in a fashion
 similar to the one described in this outlook – stronger wages and inflation beget
higher interest rates which in turn beget slower economic growth.

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