Research

4Q2019 Economic Outlook:
Consistent but no excitement

While we expect the economy to continue to plug along, although at a slower pace, what are the risks that investors should be navigating and what does the data really portend? Most importantly for real estate investors, how will this impact CRE?

February 18, 2020



The economy closed out 2019 in consistent fashion. Growth during the fourth quarter registered 2.1%, remarkably like the third quarter’s growth rate of 2.1% and the second quarter’s growth rate of 2.0%. For the year, the economy expanded by 2.3%. That represents a 60 basis points (bps) decline versus 2018 and falls in line with our forecast for growth in 2019. 

While the slowdown in growth from the first quarter of 2019 (3.1%) seems abrupt, the economy is gradually easing. Changes in the performance of aggregate demand components helps mask this somewhat, but the underlying picture is increasingly becoming clearer. Consumption, the largest component of demand, continued to expand in 2019 but at a slowing pace. Consumers remain optimistic, but a slowdown in job growth and in wage growth limits their ability to keep propelling the economy forward – consumers produced their weakest contribution to growth since 2013. 

Private investment from businesses remains weak amidst policy uncertainty, slowing global growth, and heightened geopolitical risk. Consequently, investment contributed relatively little to economic growth last year, its weakest contribution since 2016 in the wake of the implosion in energy prices. Quietly, government expenditures produced its strongest contribution to growth since 2009. 

Lastly, net exports detracted from growth during the ongoing trade war with China. Net exports consistently detract from growth and trade policy did not alter that. Looking ahead to 2020, the broad outlines remain intact. Consumers should drive growth, but at a slowing rate. Business investment should remain limited because impediments to spending have not abated. And net exports remain mired in an ongoing trade war that could burn hotter than many perceive in the wake of the phase one trade agreement. Overall, we see growth in the U.S. slowing below 2% with risks to our forecast clearly lining up on the downside.  

Overall, we see growth in the U.S. slowing below 2% with risks to our forecast clearly lining up on the downside.  

Stand (or fall) with labor demand

Frequent readers of our weekly know that we emphasize the importance of labor to the current expansion. Consumers remain active because of the strength in the labor market and increasingly the economy has relied on consumption for growth. Typically, when discussing labor, we lament that the lack of qualified workers (either in training or geographical location) has held the economy back. But we are growing concerned that gears could be shifting and demand for labor slowing, presenting a new problem. 

Job growth has clearly slowed over time since peaking in 2014 and wage growth for this cycle appears to have peaked in 2019. How much of this can we attribute to slowing demand as opposed to limited supply? Though we cannot say for certain, one of our favorite indicators has recently shown some signs of caution. The number of open jobs in the economy peaked in November 2018 and has declined inconsistently since. While some volatility occurs in any data series like this, trends still exist. When looking at the year-over-year change in open jobs, an important one emerges. During the last 20 years, when the year-over-year figure contracted for at least three consecutive months, a recession ultimately occurred. In the dot-com recession: 24 consecutive months of declines before stabilizing. In the great recession: 25 consecutive months of declines before stabilizing. Currently the data shows 7 consecutive months of declines. While that does not explicitly portend anything, it certainly warrants our attention. For now, labor seems resilient enough to keep pushing the economy along, but we expect a slowing labor market to beget slowing consumption, reducing economic growth. 

Low and slow

Other factors will likely restrain the other components of demand, particularly early in the year. Despite the recent rebound in the ISM manufacturing index, the industrial sector remains weak and private investment limited. Policy uncertainty still looms, the geopolitical landscape remains fraught with trouble, and global growth looks shaky. We expect little significant rebound in investment activity this year. Meanwhile, net exports received a one-time boost from a collapse in imports toward the end of the year. Even if imports do not rebound significantly, another leg down seems highly unlikely. 

And more broadly, growth around the world looks troubled. China, the second-largest economy in the world, remains to a large extent shut down and should almost certainly see growth negatively impacted by the coronavirus fallout. Though production is coming back online, other industries will recover far more slowly. For example, by some measures, air travel at China’s main airports has declined by roughly 80%. That will not rebound sharply as fears will linger even after the outbreak subsides, reflective of an economic phenomenon called hysteresis. China is already implementing emergency fiscal and monetary policy measures to help prop up the economy and restore confidence to the markets. 

The third-largest economy in the world, Japan, contracted at a greater rate than anticipated during the fourth quarter. The fourth-largest economy in the world, Germany, continues to generate growth at weakly positive rates, just skirting contraction. None of this bodes well for a significant expansion in exports. Coupled with Boeing shutting down the production of the 737 MAX line in January, net exports should remain a drag on economic growth. Though trade tensions eased somewhat with the phase one agreement, subsequent phases look more challenging. Potential actions mooted by the U.S. administration, such as halting deliveries to China of jet engines co-produced by GE, could reignite tensions. And government spending, already more robust than most believe, will likely not increase significantly. In short, the other major components of demand should also remain challenged in 2020. 

Bubble trouble?

The Fed cut interest rates three times in 2019, 25 bps each, due to its concerns over weak investment and the potential for spillover into consumers and consumption. While the rate cuts did not prevent business investment from contracting, they helped to shore up investment in residential structures, which provided a boost to economic growth. The Fed now seems relatively content with the level of interest rates. While we do not expect much movement from the Fed this year, one more cut could occur if growth during the first half of 2020 disappoints. With inflation (by some measures) below the Fed’s target rate, the Fed could move to try to increase pricing pressures. Clearly, low interest rates have proven to be no panacea for goods prices, but that might not stop the Fed from cutting again. The Fed will also keep a close eye on the yield curve which recently inverted again, albeit briefly. 

Yet, rate cuts are having an impact in another arena – asset prices. While the Fed has not successfully managed to boost goods and services prices broadly, its rate cuts have at least partially boosted asset prices. Some have argued that the inflation that the Fed attempted to engineer did occur, but in asset prices. This assertion holds some truth. Economic fundamentals have also certainly contributed to rising asset prices, but low interest rates play an important role as well. Beyond rate cuts, the Fed will likely continue to re-inflate its balance sheet by intervening at the short end of the curve in order to help it control short-term rates. While not explicitly quantitative easing (QE), it could also take assets out of the market and put upward pressure on prices. 

The other factor very quietly contributing to the rise in asset prices, at least publicly traded assets, is the increased role that passive investment plays today. Passive investment involves replicating an index or a benchmark that is not actively managed. Investors forego paying a manager to attempt to beat a benchmark – increasingly, research shows, the difficulty in consistently beating benchmarks after investors pay managers’ fees. Therefore, many investors have been turning away from this practice. But this also serves to inflate asset prices – many benchmarks for fixed income and equities contain the most expensive investments and passive investors continue to purchase these pricey assets without regard for due diligence or valuation, creating an upward pricing cycle. 

While these effects have not yet created a bubble per se, pricing has reached record or near-record levels for many asset classes. That creates a potential systematic risk should prices rise too much causing investors to sour on expected returns. And problematically, bubbles often only become apparent after they burst. For now, we see rising asset values in the face of building external risks as another risk to watch, especially if the Fed moves to cut rates again this year. 

For now, we see rising asset values in the face of building external risks as another risk to watch, especially if the Fed moves to cut rates again this year.  

Commercial real estate: still great

Commercial real estate (CRE) concluded another solid year in 2019. Asking rents increased in all major property types and vacancy rates remained relatively stable. Geographically, most areas performed well, with only some slight disruptions in random markets and submarkets. While the improvement in fundamentals continues to slow, we see that more as a function of the stage of the cycle than an indictment of the asset class. Looking ahead to 2020, our proprietary forecast model projects continued rent growth across major markets, albeit, at a slower pace. 

Vacancy rates look relatively stable across property types, though some localized areas with robust pipelines should continue to see some marginal upward pressure on vacancy rates. This CRE cycle continues to avoid the classic mistake of overbuilding that plagued some historical CRE cycles. Encouragingly, demand also does not look excessive, as during the dot-com bubble expansion and the housing bubble expansion. The combination of limited supply growth and robust, but not excessive demand, augurs well for space market fundamentals in 2020, even if economic growth continues to slow as we expect.

On the capital markets side of CRE, 2019 generally exceeded expectations. We concede that prices look rich. Legitimate concerns regarding pricing feel appropriate at this juncture, but CRE still offers attractive relative value vis-à-vis other major asset classes. Investors’ caution at this relatively late stage of the cycle makes sense but should not (and has not) prevented them from pursuing deals. We also acknowledge that historically investors have made the most egregious mistakes near the end of a cycle via overbidding, excessive leverage, etc. Therefore, we caution against reckless abandon. CRE still has room to run in this cycle, but that does not obviate the need for prudence.  

CRE still has room to run in this cycle, but that does not obviate the need for prudence.  

Risks and closing thoughts


After slowing in 2019, the economy seems poised for another leg down this year. But things are not imploding. Underlying momentum is cooling but remains hot enough to keep the economy from stalling. Headwinds should continue to build throughout the year but look surmountable. Consumers are still spending, which remains critical to demand given the challenges ahead with private investment and net exports. Therefore, the labor market remains the lynchpin of this expansion. While the labor market remains strong, contraction in the economy seems a distant prospect. 

Yet many wild cards exist: trade policy, the coronavirus, domestic political uncertainty, etc. If any of them unfold the wrong way or occur in the wrong combination, that could then create problems. Such idiosyncratic risks prove unpredictable – literally beyond anyone’s ability to consistently predict or forecast. That often unsettles markets and economic participants. But the economy and the markets continue to blithely contend with these risks and plow ahead. 2020 looks set to be another such year, but only time will tell for sure. 

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