The economic outlook
improves, but does CRE?
The impact of the pandemic on commercial real estate may be tied to “pre-existing conditions”
- Economic data generally tracking more positive
- Consumers and businesses showing some resilience
- Sledding gets tougher after third quarter
- Fiscal stimulus remains a key variable
- CRE performance largely depends on health heading into pandemic
Admittedly, identifying positive indicators right now remains difficult. But somewhat quietly things have improved throughout the third quarter despite ongoing challenges. Although things have changed marginally, they still mark a departure from earlier in the year when pessimism dominated the outlook. Projections have not swung to optimism per se, but the further we press on into the quarter, the better the quarter looks. How did that occur and what lies ahead?
Consumers and businesses show resilience
A resilient consumer provides the key support for improved optimism. Last week the second print of second quarter GDP showed a slightly smaller contraction in the economy, making our forecast for the quarter almost spot on! Both consumption spending by consumers and private investment by businesses contracted by a smaller amount than originally calculated. Though the second quarter still shows the worst quarterly contraction on record by far, the data gradually improved as the second quarter unfolded. That brought economic momentum as the calendar shifted into the third quarter. Data through July generally supports this thesis. The labor market continued to gradually heal with a net 1.8 million new jobs created. Spending on the part of consumers continued to advance. And businesses started to feel a bit more confident about deploying capital, with durable goods orders continuing to grow at an accelerating pace. It seems as if after a resurgence in the second quarter, new daily COVID-19 cases are once again decelerating.
But a pivotal event occurred at the end of July – the CARES act expired without a replacement. Concern over the economy began ramping up because of the import support that fiscal stimulus provided to the economy. Thus far, that alone should not prevent the economy from rebounding robustly in the third quarter, reaffirming our view that the recession has already ended. And housing remains a bright spot, with home sales, permits, and starts all reflecting strong underlying demand for housing. Consequently, we are revising our third-quarter growth estimate upward to reflect this, with the range across our broad scenarios now in the 9% to 30% range. Clearly, one month of the quarter remains, but to date the momentum has outweighed the drag from the expiration of fiscal stimulus.
What comes next?
But what follows the third quarter? We continue to believe that growth will persist after the third quarter, but at a slower rate. Job gains have already slowed considerably, spending is slowing down, and the uncertainty surrounding the expiration of fiscal stimulus remains. That last factor will have a huge influence on where the economy heads during the fourth quarter and on into the next year. Both our generalized base case and upside case, drawn from thousands of simulations, assume Congress can come to some agreement and provide additional funding, likely between $1 trillion and $2 trillion. Our downside case assumes they do not, potentially triggering a backslide in economic growth. And of course, the trajectory for the pandemic will continue to play a large role. We will need to see how the pandemic unfolds once cold weather returns to the Northern Hemisphere as we head into the fourth quarter.
The Fed’s new stance on inflation
Additionally, we are now also factoring in the Fed’s new stance on inflation. Last week the Fed announced the creation of its flexible average-inflation targeting regime. That will allow inflation to rise above its target rate of 2% during certain phases of the business cycle. The Fed also recognized less of a need to tighten policy despite an incredibly tight labor market, provided inflation remains below target. That brings up an important metric that was once thought outdated – the yield curve. During the last few years as the yield curve inverted many happily dismissed it. While increasing short-term rates and the inverted yield curve of the last couple years did not cause this recession, it still presented an important signal about slowing economic growth. So much so, that the Fed had to backtrack and cut rates heading into the crisis. The yield curve still predicted this downturn (even if on a technicality). But more importantly, the Fed recognized that there are asymmetrical risks to raising rates too quickly during relatively tepid recoveries, which we could once again experience. Therefore, we foresee the Fed keeping rates low for several years, likely into the middle of this decade, which should provide support for the recovery.
What we are watching this week
Both the ISM manufacturing and nonmanufacturing indexes for August should show a continued rebound in economic activity, with both pushing into expansion territory. The employment situation release for August should reveal continued job gains, likely above 1 million, even if the pace has declined considerably from a few months ago.
What it means for CRE
For commercial real estate (CRE), the marginal improvement in the outlook helps, but does not constitute a panacea. While the major property types and metro areas are all grappling with the downturn to various degrees, no one is coming through this unscathed. That said, we can see the impact of the pandemic on CRE similarly to how we view the pandemic’s impact on individuals. If a property sector or metro area had “pre-existing conditions” heading into the pandemic, they will likely fare worse. But for those that were in a healthier position, they should weather the downturn relatively well. And of course, the more micro one gets, even down to the property level, the more appropriate this analogy.
Thought of the week
According to research between 1975 and 2000 an average of 282 companies went public via initial public offering (IPO). From 2001 forward that figure fell to 115 companies.