Research

A downshifting of growth

The near-term outlook for the economy shows it remaining robust, but growth is already slowing down. During the third quarter economic growth registered 3.5 percent at an annualized rate. That represents a deceleration from the 4.2 percent annualized growth in the second quarter. Although the economy is generally following the pattern observed through most of the current expansion – growth accelerating toward the middle of the year before slowing as the year ends – expansionary fiscal policy is driving the underlying push for growth, something we haven’t seen in recent years. 

Befitting an economy driven by a largely demand-side fiscal stimulus via tax cuts and spending increases, consumption and government spending drove growth during the third quarter, with growth in inventories also contributing. Fiscal stimulus is contributing roughly 50 to 60 basis points to economic growth this year. As expected, net exports detracted from growth, reversing the boost from the second quarter in the rush to get out ahead of tariff implementation. We continue to believe that tariffs will restrain economic growth by 20 to 30 basis points versus a baseline scenario. More concerningly, investment is not accelerating despite the significant corporate tax cut passed last year. Nonresidential fixed investment grew by a cumulative 5.1 percent during the first three quarters of 2018. During the same 3-quarter period last year, before the passage of the corporate tax cuts, nonresidential fixed investment grew by 5.0 percent. 

If not into investment, then where did the tax savings go? 

Exactly where we thought it would – into share buybacks and dividend increases, which are on track to reach record nominal-high levels this year. 

Business leaders are struggling to find investment opportunities, so they are plowing their tax windfall back into their companies. While fixed investment could increase in future periods, we see little evidence of that thus far. 

Our underlying thesis on the economy remains unchanged. We expect fiscal stimulus to continue to impact the economy, but gradually fade over time. Scarcity of all inputs will continue to put upward pressure on prices, increasing inflation gradually over time. In turn, that will push interest rates higher. Throw in mildly restrictive trade policies (which could intensify – risk still lies on the downside) and we have a perfect storm for an economic slowdown. 

We foresee economic growth slowing to an annualized rate of roughly 3 percent in the fourth quarter, bringing growth for 2018 to around 3 percent. For 2019, we expect growth to slow toward the mid-2-percent range, with further slowing in 2020.

We are not explicitly calling for a recession (which remains an almost impossible task), but a slowdown looks increasingly set to occur over the next few years.

For commercial real estate (CRE) supply-demand fundamentals look to remain firm, even as slowing economic growth brings moderation in net absorption. Restrained construction volumes prevented CRE markets from getting over their skis and pushing up vacancy rates in this expansion. We expect construction volumes to slowly decline, helping to keep balance in the space markets. But we anticipate that vacancy rates across most major property types will continue to drift higher and rent growth will continue to slow, indicating that markets are likely past peak though still robust. CRE capital markets have maintained general strength. Transaction volumes continue to head lower with much dry powder still sitting on the sidelines. Many in the market are waiting for something: the next downturn or some random idiosyncratic event, perhaps. Pricing has held up well. But signs of strain are gradually emerging. Interest rates have risen by roughly 100 basis points over the last year and we reiterate our position that while individual rate hikes do not mean much at the margin, the cumulative impact of rate hikes can hold meaningful impact, particularly as fundamentals slowly weaken. 

Our proprietary forecast model reflects our outlook for the economy. We forecast gradually rising vacancy rates and slowing rent growth over the next few years. The one exception remains the industrial market where record-low vacancy rates continue to drive rent growth. On the capital markets side, we foresee flat to slightly up cap rates over the forecast horizon. We will detail our forecast in our forthcoming forecast outlook report, due out in early December.

Labor remains the linchpin

With the stimulus-fueled economy accelerating, the labor market responded accordingly with employment growth rebounding in 2018 after gradually declining for the last few years. Employment gains have averaged 210,000 per month over the last 12 months, 213,000 per month in 2018, and 218,000 per month over the last three months.  We anticipate that the level of job gains will decline over the next year as the boost from fiscal stimulus fades. Over the last two months unemployment has reached levels unseen for roughly half a century. The U-3 headline unemployment rate fell back to 3.7 percent, matching its lowest level since December 1969 and the U-6 underemployment rate fell to 7.4 percent, its lowest level since April 2001. The ongoing labor shortage in the U.S. continues to worsen, with a record 7.1 million open but unfilled jobs as of August.

Even as job gains slow, we expect the labor market to get tighter, competition for qualified workers to intensify, and unemployment to continue to fall.

Due to the ongoing tightening in the labor market, wage growth finally broke through the 3-percent threshold in October as we predicted. In August, we warned that despite modest wage growth, wages had leapt twice during the current expansion and could again. That appears to be the case. For the third time during the current run, wage growth surged in a short period of time. Between April and August year-over-year wage growth accelerated 40 basis points, like surges from 2012 and 2015. Moreover, data from the Employment Cost Index (ECI) also supports the tightening wage thesis, with wages for private workers also growing by 3.1 percent year over year. Gradually, competition among employers is causing them to raise wages to attract and retain qualified workers.  The rising number of open jobs indicates that demand for workers continues to outpace supply of workers, even as employment grows and wage growth accelerates. We foresee unemployment remaining below 4 percent for several months which will keep competition intense and push up wage growth, maintaining rates above 3 percent.

With wage growth breaking above 3 percent, inflation comes under closer scrutiny.  For much of the current expansion, inflation was considered benign, a hallmark of the “Goldilocks economy.” But wage pressures often signal rising inflation because even if companies can absorb higher wages without margin erosion for a time, that will not last indefinitely. And even without the pressure from accelerating wage growth almost all major measures of inflation continue to show rising prices throughout the economy. Moreover, virtually all the major indexes show inflation at or near the Fed’s 2-percent target rate, including the core personal consumption expenditures (PCE) index, the Fed’s preferred measure of inflation. We continue to foresee gradual upward pressure on inflation, like what is occurring with wage growth. 

During the third quarter, interest rates started increasing again, continuing the upward trend from the last few years. Earlier in the year it appeared as if interest rate increases were stalling, but that proved short-lived. What initially seemed like yields moving too quickly earlier in the year quickly reversed course and then seemed as if rates were moving too slowly after rates pulled back earlier this year. The underlying trends in the economy remained firmly in place, strengthening somewhat. Eventually, the bond market came around to the same conclusion that we had – the U.S. economy was distancing itself from other major economies of the world whose economic growth is slowing in 2018. Since that market realization, rates and yields across durations and instruments are up roughly 100 basis points over the last year. During the period the Fed raised the Fed funds rate four times, 25 basis points each. Thus far in 2018 it has raised three times, 25 basis points each time. We believe that the Fed will raise once more in December, 25 basis points. And we continue to see the 10-year Treasury yield remaining slightly above 3 percent. 

Over the last year, the yield curve (measured by the 10-2 Treasury yield spread) has flattened by roughly 50 basis points.

Unless something derails the Fed from their current path, and we see little evidence of that thus far, the Fed will hike rates four more times over the next 12 months, 25 basis points each.

That will almost surely invert the yield curve by the end of 2019 at the latest. Recall that an inverted yield curve typically signals a recession sometime 6-18 months after inversion. And the Fed has turned more hawkish in recent periods, with several officials publicly claiming that they will likely have to push interest rates past the neutral point to a rate that slows economic activity to keep the labor market and inflation from overheating.  Some have questioned the Fed’s decisions to keep raising rates because inflation remains rather low. But that criticism fails to account for the role that higher rates play in keeping inflation in check. Scarcity of inputs, particularly in the labor market, have and should continue to push prices higher. Opposing this pressure, higher interest rates make certain purchases more expensive for borrowers, helping to tamp down demand and keep prices from spiraling higher. This creates a tug of war and in the absence of the rate hikes, it seems like that inflation would be increasing at a faster pace, even if not at alarming levels yet.

Risks and closing thoughts

We have not altered our outlook for the economy for 2018 or 2019, but we see risks growing over time. The current unemployment rate sits below objective measures of the natural/non-accelerating inflation rate of roughly 4.5 percent. Therefore, wage growth should continue to head higher which increases the probability that inflation will continue to trend higher, or at a minimum cause the Fed to keep raising rates to stay ahead of inflation. And we know that higher interest rates ultimately lead to a slowing in economic growth if not an outright recession. We also know that recessions typically occur roughly three years after the unemployment rate breaks below the natural rate, which occurred back in the summer of 2017. 

We remain pessimistic about the prospect for détente over trade. Trade relations have worsened since the second quarter with the Trump administration imposing tariffs on additional Chinese imports and threatening to impose tariffs on all remaining imports that are currently not taxed. While this presents only a minor drag on the economy, it contributes negatively at a time when fiscal stimulus is losing steam and monetary policy is tightening. It will only add to the jitters and nervousness in the markets surrounding earnings growth which look like they have peaked, at least in some industries. And the rift between the hard data (which has looked good) and the soft, sentiment data (which has looked great) might finally be converging.

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