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Beware the three bears

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Goldilocks economy still present

Much like its namesake, the Goldilocks economy is not departing in a hurry. Though not slumbering, the inflation data released last week did not stir either. Both the headline and core producer price indexes (PPI) for April came in below expectations and decelerated on a year-over-year basis. PPI had been running hot for the last few months so April's data does not look like the start of a trend. Meanwhile, the consumer price index (CPI) for April also fell below expectations. But unlike the PPI, the headline CPI accelerated while the core CPI held steady on a year-over-year basis. While some of this upward trend stems from weak wireless services pricing last year, the underlying trend in the CPI clearly points upward. Following suit, import prices also increased at a slower-than-expected rate. But import prices' year-over-year growth rate exceeded overall inflation measures. Following on the heels of modest GDP growth in the first quarter, the not-too-hot, not-too-cold economy remains in place for now.

What about the three bears?

As always, we caution against reading too much into one data point in a series. And the underlying upward trends in the three bears – wage growth, inflation, and interest rates - remain in place. While the growth rates for those three metrics could suddenly accelerate, we were never primarily worried about a sharp acceleration. Our main concern remains the cumulative impact that slow, continued upward increases in the three bears will eventually place on the economy. We never anticipated that these pressures would emerge immediately. And we still hold to our thesis that slow upward pressure on wages, inflation, and interest rates will eventually drag on economic growth.  The underlying upward trends have not reversed. The three bears have not come home to roost yet. But we expect all three measures to continue upward, particularly as economic growth accelerates in the middle of this year.

Oil bucks the inflation trend in April

While most metrics showed modest inflation, oil recently broke through the $70 per barrel threshold, a level we haven't seen in years. The combination of somewhat restricted output, increasing demand from the growing global economy, and geopolitical tension are pushing prices higher. The Trump administration's decision last week to withdraw from the nuclear agreement with Iran furthered tensions which upped pressure on pricing. Over the last year, petroleum has increased more than 50 percent year-over-year. As previously mentioned, inflation is already trending upward. Higher energy prices would only exacerbate inflation which is already eroding purchasing power. Wages are growing 2.6 percent on a year-over-year basis while headline CPI is growing 2.5 percent year-over-year.

Consumers' hold virtually no real power to increase
real spending if inflation is offsetting wage growth.

Higher oil prices are already limiting consumer confidence and sentiment. If oil prices remain at elevated levels purchasing power will remain limited, undermining economic growth and offsetting some of the benefits from the fiscal stimulus passed, even if higher oil prices spur greater investment in the energy industry.

 



Implications for CRE

For commercial real estate (CRE) the implications of recent economic data reflect the Goldilocks reality: we are not dismayed nor heartened by recent readings. Modest inflation readings indicate that the economy is not yet running too far ahead of potential. But at the same time, the underlying trends in price indexes are all heading upward which we expect to continue. Those trends should spur the Fed to rates at least two more times this year.

This leaves our guidance unchanged. The outlook for CRE in the short term remains firm with accelerating economic growth underpinning fundamental and capital markets, certainly to a greater extent than in the absence of fiscal stimulus. But the cumulative impact of higher wages, prices, and interest rates should weigh on the economy and CRE in the medium term. And risks are continuing to build, the most prominent of which concern international trade. Tensions with China were not defused by administration officials' recent trip there and NAFTA negotiations remain uncertain. Geopolitical risks appear to be shifting, not diminishing. Many asset classes, including CRE, are expensive, even when viewed relative to earnings or net operating income. A pullback in asset prices could dampen consumer spirits, particularly if oil prices continue to rise. 


What we are watching this week

Weakness in auto sales should restrain headline sales growth for April. But the less volatile core retail sales should show a strong gain, indicating that any weakness in consumer spending has largely ended. Housing starts and building permits for April should show a continued, gradual upward trend. But both metrics remain muted, below levels from even before the housing bubble last decade. Weekly unemployment claims should hover near recent lows reflecting the continued strength and tightness in the labor market.


Thought of the week

The Bank of England (BOE) decided to leave interest rates unchanged after weak inflationary readings.





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